Buying or selling a home can quickly become confusing when you are not used to the process. The situation isn't helped when you encounter unfamiliar terms used in real estate transactions. I can tell you from being in the real estate business for the past thirty-three years; one of the most questioned topics is about the money a buyer comes up with when purchasing a home. Buyers will often ask what the difference is between a down payment and an earnest money deposit. While the concept isn't all that hard to grasp if you're a first-time buyer, it can seem foreign. Keep reading, and you will get a better understanding of how these two real estate terms differ in their meaning and function.
What Is An Earnest Money Deposit?
The earnest money deposit is the funds that a buyer puts into an escrow account once the seller has accepted the offer. This is done to demonstrate that the buyer is genuine about the offer they have made. This gives the seller the security of knowing that they will have some compensation should the buyer fail to close the deal. Without having "skin in the game," a buyer would be free to walk from the transaction Scott free at any time. Obviously, that would not be a level playing field for the seller. Any homeowner is going to want to know their buyer is fully committed to getting to the closing table.
How Much Should an Earnest Money Deposit Be?
It is usual for the deposit to be in the range of 1 to 5 percent of the price agreed. This can rise to 10 percent depending on the market situation or if the seller feels they need more security. If, for example, the buyer has offered to pay cash, the seller may ask for a more significant percentage to show the buyer is serious. This deposit is open to negotiation. If the seller isn't happy with the amount suggested by the buyer, they can turn down the offer or ask for a higher sum of money. Quite often, with the purchase of new construction, a builder will ask for a ten percent earnest money deposit. They may even request to use these funds rather than having them held in an escrow account.
Earnest Money vs. Down Payment
Having been a real estate agent for the past thirty-three years, I can tell you first hand that buyers often confuse the difference between earnest money deposits and their down payment funds. These are two very different things. The earnest money is security for the seller, while your down payment is funds used to purchase the property other than what you will be mortgaging.
What Happens to the Earnest Money Deposit?
When the purchase agreement is signed, the earnest money will need to be available. This deposit can be paid via a personal check, which will be held by a third party rather than going to the seller. The title company or real estate agent will deposit the check into an escrow account, and it will be accounted for at the time of closing. These funds will be used as part of the down payment or go towards the closing costs of the sale. If the buyer doesn't continue with the sale under the terms of the contract, they risk losing this deposit. There may, however, be some circumstances where they are entitled to this money back. It will depend on the details contained in the purchase agreement, which may avoid the need for legal action to recover the deposit. Some of the common ways a buyer can lose their earnest money include the following:
- Not following the time frames in the contract, such as letting their mortgage contingency expire without a written request for an extension.
- Getting cold feet and just walking away from the transaction.
- When you waive contingencies like a home inspection that really should have been in the contract, to begin with.
A Down Payment
When a down payment is involved in the purchase of a house, this is paid directly to the seller. The mortgage lender will then pay the remainder of the purchase price. This money is separate from the mortgage and will need to be found from savings or the proceeds of the sale of your previous house. When the sale is closing, the payment will be required. This is generally through a cashier's check or bank transfer.
How Much is Required for a Down Payment?
The lender will normally set the amount of money required for the down payment. This amount will relate to the mortgage value, with the typical minimum being 3 percent of the price of the house. However, real estate agents often recommend a down payment of 20 percent if possible, to avoid paying private mortgage insurance.
While 20 percent down has been considered the standard payment amount for a long time, there are now tons of lower down payment loans available.
For many buyers, it can be challenging to raise such a large amount for an upfront payment. This is particularly hard for first-time buyers and people who are stretching their finances. It should also be remembered that there are many other expenses to consider as well and set money aside for. For example, there are the closing costs, which could amount to 2 to 4 percent of the purchase price. It is almost inevitable that other expenses will blindside you through the process, so it is advisable to have access to extra funds should the need arise. While banks are often open to lower down payment amounts, this could lead to other additional costs like the aforementioned private mortgage insurance. This will be a monthly cost to protect the lender should you fail to meet your payment schedule. This insurance can be a substantial extra expense, typically amounting to around 1 percent of the total mortgage value. It can be a great feeling of achievement when you can purchase your own home. Hopefully, our brief explanation of the deposit process will give you a better understanding of your options and what to expect when you do.
Final Thoughts
Hopefully, after reading, you now have a better understanding of how an earnest money deposit differs from your down payment. While both amount to money coming out of your pocket, they are used for very different things in the process of buying a home.