Earnest Money vs. Down Payment: What’s the Difference?
December 7th, 2022
Is real estate jargon getting the better of you? Don’t worry – you’re not alone. The real estate industry is full of mind-boggling jargon and complex notions, so there’s generally a lot of confusion around a significant portion of real estate terminology, especially among first-time buyers. Although both are real estate terms dealing with cold cash and are often used interchangeably, earnest money and a down payment differ in more ways than one.
In this article, we shed some light on this burning question that probably weighs heavily on the minds of many to help you navigate the blurred lines between these two terms and put the “earnest money vs. down payment” debate to rest once and for all.
Let’s stop scracthing our heads and dive right into it.
What is Earnest Money?
Earnest money deposit, or simply earnest money or EMD for short, represents the initial funds a prospective buyer is asked to put down once a seller accepts their offer. Also known as a “good faith deposit,” earnest money is considered a gesture of goodwill, demonstrating that the buyer is serious about following through with the purchase and incentivized to fulfill their contractual obligations.
Although not an official requirement, making an earnest money deposit is highly recommended and even necessary in more competitive markets.
It primarily safeguards the seller if the buyer backs out of the deal or breaks any contingencies listed in the purchase contract, allowing the selling party peace of mind. However, the earnest money is a win-win because it also protects the buyer in case of a breach of contract on the seller’s behalf and improves their chances of securing the sale.
How Does It Work?
An earnest money deposit (also called an escrow deposit) is determined during the negotiating phase, drafted into, and made upon signing the purchase agreement or the sales contract. One of the most common questions is: “How much is an earnest deposit?”
Since earnest money is negotiated, there's no set amount. It can range anywhere from 1-10% of the property’s purchase price, depending on several factors, such as the real estate market competitiveness, type of property, and financing.
In most real estate transactions, earnest money funds are held in an escrow account until closing. If you're wondering who keeps the earnest money after the property closes, keep in mind this depends on whether the buyer followed the contract terms. If the deal happens to fall through, the earnest money amount will be provided to the party legally entitled to it.
What is Down Payment?
In real estate, a down payment refers to the initial amount of money that a buyer pays upfront for a property or another asset in a real estate transaction and other expensive purchases to reduce the amount of money they will have to borrow (lend).
How Does It Work?
Down payments are most often a part of obtaining a loan. There are usually minimum down payment requirements that need to be met for it to be approved, which can vary depending on the type of mortgage, type and purchase price of the property, and the borrower's financial circumstances, and range anywhere between 5-20% of the total purchase price (also known as a loan-to-value ratio, or LTV).
Most conventional loans allow for smaller (or no) down payments. However, to compensate for the risk of putting less than 20% down, they require the borrower to purchase private mortgage insurance (PMI) to be protected from losses by the insurance coverage.
Putting more funds upfront will reduce the amount of money you’ll have to borrow from the lender and help you avoid purchasing PMI, which translates into lower monthly mortgage payments. However, if making a large down payment will stretch your savings too thin or take too much time to save, making a lower down payment is a wiser move.
Down Payment vs. Earnest Money: Key Differences
Earnest money deposit and down payment might seem like two sides of the same coin at first glance. However, there is much more to these real estate terms than meets the eye.
Let’s take a more in-depth look into the crucial differences between earnest money and down payment:
Recipient of the Money
An earnest money payment serves as a promise to the seller of a property or another asset, while a down payment is for the lender providing your mortgage loan. After closing, the earnest money will be given to the party legally entitled to it, while the down payment funds will be sent directly to the seller of the purchased property.
Intent & End Goal
Earnest money deposit is made to provide security to both parties included in a real estate transaction – the seller and the buyer. At the same time, the down payment is used to secure the funds for the buying process from the lender when you’re using a mortgage loan to finance the purchase and lower your monthly payments.
Amount
The average earnest money deposit ranges between 1% and 3%, although it can get as high as 10% in highly competitive markets. The minimum down payment required is usually higher than the negotiable earned money deposit and can range anywhere between 5% and 20% of the purchase price.
Earnest Money Deposit vs. Down Payment: The Final Verdict
To sum up, both earnest money and the down payment are upfront payments to secure a property purchase or the funds for one. In the most straightforward layman's terms, the earnest money deposit is a monetary promise made to the home seller, while the down payment is a promise to the loan or mortgage lender.
Whatever you do, don’t make promises you can’t keep when buying a home. Talk the talk – team up with an experienced company like Lightspeed Escrow for a swift and smooth real estate transaction, from making an earnest money deposit or down payment to the closing stage. Whatever services you might need, we’re here to make it a breeze.
FAQ
What if I Don't Have Earnest Money?
If you don’t have good-faith money, don’t despair because that doesn’t mean you’re out of options. You can solve this bottleneck by requesting a waiver of earnest money, raising money with wholesaling, or looking into zero-down financing options such as hard money loans.
Does Earnest Money Go Towards Down Payment or Closing Costs?
At the close of any escrow account, the deposited earnest money funds can go towards the down payment and closing costs to help close the deal. On the other hand, down payments only go toward purchasing a property.
Is Earnest Money Refundable?
Yes. As long as a sale goes through successfully and no deadlines or contract agreements are breached, the earnest money is refundable, and home buyers can get their earnest money back in full.
Depending on the contingencies listed in the purchase agreement, the buyer can also walk away from the contract and receive their earnest money deposit back in full if the seller breaks the contract in any way.
Is the Earnest Money Deposit Part of the Down Payment?
It can be. The earnest money you pay upfront when purchasing real estate can be applied to either the down payment or the closing costs.
