Understanding How a Down Payment Differs From Earnest Money

Are you thinking about buying your first home? When you start the home buying process for the first time, you will come across many new terms and phrases that are probably foreign to you.

For instance, you need to know the difference between earnest money and a down payment on a home. Having been a real estate agent for the past thirty-three years, I can tell you some buyers confuse the two.

Needless to say, both of them have to do with money. Not only are both used in the United States, but most countries in the world use some form of earnest money and down payment funds.

Keeping the different nuances of these two real estate terms straight is essential. If you are not one hundred percent sure, speak to your real estate agent or attorney.

The reference above at Maximum Real Estate Exposure, however, is a comprehensive as it gets on what an earnest money deposit is and how it works. You will also learn precisely how a down payment differs from earnest money. It's well worth reading.

What You Need to Know About Earnest Money

Earnest money is also called an escrow deposit. Many folks in the real estate industry also refer to it as a "Good Faith Deposit." It is used to protect both the buyer and seller.

Primarily, it exists for the advantage of the seller, but there are benefits to earnest money for the buyer as well. In most states, once an earnest payment has been received and deposited in an escrow account, the seller is legally obliged to sell the home to the buyer who made the payment.

If the buyer decides not to go ahead with the purchase after their contingencies have passed, the seller is entitled to the full amount of the earnest payment. It is very important to be aware of that.

The payment is really a form of security or insurance for the seller - hence the term "good faith." The seller knows that once the earnest money has been paid into an escrow account and any contingencies they may have are satisfied, the buyer is not likely to withdraw from the deal.

Most often, the earnest money deposit is held by the seller's real estate broker. With private sales completed for sale by owner, it's typical that the owner's attorney will hold the deposit in escrow.

What Are Typical Contingencies?

Earnest money will become the seller's if the buyer does not perform under the conditions of the contract. In most real estate sales, there are some common contingencies as follows:

• The home inspection - home buyers typically have a due diligence period where they are allowed to inspect the property for any significant defects. Other than the condition of the building itself, buyers may check out other things such as whether there is radon, lead paint, mold, adequate and potable water, etc. If the buyer discovers issues with any of these items, they may notify the seller in writing and get their earnest money back. Not uncommon at all when purchasing a fixer-upper property.
• Mortgage financing - most buyers will have a mortgage contingency that describes how much they are financing and by when they will have a mortgage commitment. If a buyer is not able to procure financing and they notify the seller in writing, they also will get their earnest money back.
• Any other contingencies - there could be any kind of contingency in a real estate contract. Typically, there will be a date by which the contingency must be satisfied.

Once the dates lapse on these contingencies, the buyer's earnest monies become at risk if they do not perform under the conditions of the contract.

In other words, there are ways you can lose your earnest money deposits if you're not careful. Buyers should be keenly aware of these, so there are no unexpected problems.

How Much Are Earnest Money Deposits?

One of the first things most buyers will ask is how much is the earnest money they will need? The answer can vary from state to state. You will need to consult a local real estate agent to find out what is normal in your area. For example, in Massachusetts, the most common earnest money deposit is five percent of the purchase price.

Generally speaking, the average earnest payment is between 1 - 5% of the purchase price of the home. When in a hot real estate market favoring sellers, it's essential not to try to offer less than the norm for your escrow deposit. You may want to offer more than the norm to sweeten the offer.

But, you should keep in mind that the earnest monies are negotiable. Never pay more than you are prepared to pay. The payment is subject to a contract. Read through and make sure you understand all of the ins and outs of the contract.

One other important thing to note is that the earnest money deposit for new construction can differ from a re-sale home. With new construction, it is not uncommon for builders to ask for a larger deposit. In many locations, the deposit amount will be ten percent of the sale price.

A decent percentage of time the earnest money deposit will not be held in an escrow account by used by the builder for the construction project. Given this, it becomes imperative for due diligence to be done by the builder before handing them funds.

What You Need to Know About the Deposit Payment

The deposit down payment is paid directly to the seller of the home by the buyer. It does not come from the lender or the finance company. Most down payments range from 3% to 20% of the purchase price. Years ago, twenty percent down when buying a home was the holy grail of real estate sales. That is no longer the case.

Many first-time buyers find it hard to find 20%. If this is the case, you can make a smaller deposit, but you may find yourself subject to private mortgage insurance. It is important to be aware of this as it can add an extra expense to the mortgage.

Private mortgage insurance can be a significant chunk of change each month. Most homeowners will work towards stopping paying private mortgage insurance as soon as possible. This is why you want to make sure you stick to a budget and save up as much cash as possible.

The down payment is generally made in the form of a personal check, cashier’s check, or wire transfer. Before you make it make sure you are happy with everything. Read the contract carefully and ask for legal advice if you are unsure.

Getting Pre-Approved and Your Credit Score

Before you start the home buying process, make sure that you have been pre-approved for a mortgage. Once you have found your dream home, it will make the buying process so much easier.

But, then again, buying a home starts before you start looking for a property. You also need to make sure that you have an excellent credit score. Don’t hesitate to check if you are not sure. If you are planning to buy a home in a couple of year's time, planning ahead is essential, and that means being financially prepared.

There are more costs associated with buying a home than earnest money and the down payment. Familiarize yourself with closing costs and lending costs to make sure you don’t come across any surprises. Ask your mortgage brokers smart questions so you are not surprised by anything in the home financing process.

Yes, owning your own home is nice, and is the way to go, but it is also a major undertaking. Consider it as an investment as much as a home purchase, and you are thinking along the right lines. It is an emotional journey that can have a lot of ups and downs, even for the most experienced buyer.

Final Thoughts

Understanding the difference between earnest money and a down payment is a key component of buying a house. Make sure you understand contract timelines, financing, and everything else it takes to have a successful home purchase.