Earnest Money vs. Down Payments
You’ve decided to buy a home. You’ve saved your money. You shop around. You’ve visited places so lavish and large, that you’re surprised a butler didn’t greet you at the door. You’ve visited closets that a hopeful real estate agent has dubbed a “starter home”. Just as you’ve become annoyed at the process, you find the perfect home.
You visualize your furniture in each corner, see your own art on the walls, and almost hear your children stomp through the halls. You make an offer. This is the time you need to know about earnest money. If you don’t put down earnest money, and someone else does, you may lose the home. Similarly, if you go into a mortgage lender and your down payment isn’t enough, the lender may not finance you. Today, we’re going to dive into these two terms, so you know before you go!
Earnest Money vs. Down Payments
What is Earnest Money?
Earnest money is a deposit given from a prospective buyer to the seller, and has nothing to do with the lender. As the buyer, you provide it along with your offer on a home. This can catch some people off guard, especially if they’re low on cash awaiting the sale of their current home to buy a different one.
Contrary to some opinions, earnest money is not a scam. If everything goes to plan with the home purchase, your earnest money goes toward your down payment (in other words, it doesn’t “cost” you any extra at the end of the day). However, if you choose to back out of the purchase for reasons that aren’t covered in your contingencies, the seller keeps the money. Essentially earnest money shows that you’re serious about the purchase of the home.
If you have the cash to offer, offering earnest money can make you more attractive to the seller and convince them to choose you over another buyer. The person offering more earnest money seems least likely to waste a seller’s time by backing out of the sale for arbitrary reasons.
Most earnest money has contingencies which allow you to get that money back if you aren’t able to secure the loan or you find out the home is in poor condition. It’s always a good idea to get a home inspection from a certified professional during your purchase process so you know the exact condition it’s home is in before you buy it. Buyers typically have the option to back out of the purchase and get their money back if the home doesn’t pass inspection unless they waive their contingencies.
How much earnest money is normal?
Usually, an earnest money deposit is between 1% – 5% of the total sale, though for newly built homes, that could be higher. You might even offer more to edge out potential competition.
Earnest money deposits are usually worked out between real estate agents. You sign a sales contract, which outlines the amount and the terms. Once agreed upon, the money is held in escrow. This means that a third party holds on to the money while the housing agreement is underway. Your sales contract will outline your contingencies for a return of your earnest money. These may be major issues uncovered from a home inspection, uncovered problems with the title of the house, or you run into a medical emergency that puts your finances into question. You can waive all of these, but you would lose your earnest money deposit, sale or not.
What is a Down Payment?
A down payment is the amount of cash you can put toward your home, meaning that you’ll finance the rest. A down payment’s size greatly changes your home purchase, as a bigger down payment means a smaller loan. A small down payment means more interest paid over time, and may even require a co-signer. It also means you may asked to purchase private mortgage insurance (PMI).
The magic number to strive for is 20% of the purchase price. Aside from your credit score and your debt to income ratio (what you owe vs. how much you earn), a lender is also concerned with a loan-to-value ratio. Your goal is to make this ratio as low as possible. If you cover 20% or better, your loan to value ratio is 80%. Lower that percentage, and you may have options in what your loan looks like. Perhaps you’ll pay a bit more per month to lessen the interest paid overall. Perhaps you’ll pay less per month, so you have more spending money for the little things, like investing. Either way, a larger down payment provides your lender assurance that you can afford the loan, and with that assurance comes options.
There are many types of loans you can get, based on down payment sizes. Here are the main ones in a nutshell.
- Conventional Loan – This is through a private lender, and if you fall under the 20% down, expect to provide PMI. Most loans and advice are based on conventional loans.
- Government Loan – There are strict rules about what you can use these loans for (for example, a primary residence only instead of a rental property). They may allow you as low as a 3.5% down payment and already have the PMI built into them. As as the name implies, are these backed by the government, like VA and FHA loans.
Is saving up for that high down payment worth it? Yes. A bigger down payment saves you money over the life of your loan. For starters, you don’t have to pay for PMI. Your loan payments will be less per month, and your loan will have a lower interest rate since lenders take on less risk. Of course, this will take longer to save for, and you don’t see these benefits right away. There are also advantages to having more cash on hand instead instead of your maximum down payment. For example, unexpected home repairs often are paid out of pocket, so keeping some savings on hand is crucial.
Your down payment money will be paid to your lender, upon closing, at an agreed-upon date. The lender will pay the full cost of the home to the seller. The house will be yours — congratulations!
Now that you have some background on how this all works, go out and find that dream home!