Earnest Money vs. Down Payments
Once you’re ready to buy a new home and you’ve finally saved money for a down payment, it’s time to start the house-hunting process. Whether you’re in the market for a quaint townhome in the city or a decent-sized single-family home in the country, it’s important to understand the difference between earnest money vs down payment so you can make sure you’re spending your money wisely.
Before you envision your furniture in that brand-new living room or your favorite artwork hanging on the walls, you may consider offering the seller some earnest money. If you don’t give the home seller earnest money and another buyer does, you could lose out on the home of your dreams. Let’s say you pay the earnest money, but now you don’t have enough cash saved up for a down payment when you approach the lender for financing. If this happens, your lender may decide they can’t finance you, and you’ll potentially lose out on the deal.
Let’s take a closer look at the differences between earnest money and down payments, so you can be in the know before you shop for a beautiful new place to call your own.
Earnest money deposit vs down payment
You may have heard the term earnest money deposit before, but it’s completely different from making an actual down payment on a home. Here are some important things to remember about earnest money deposit vs down payment and how they’ll apply to you when you’re ready to make an offer on a property:
What is earnest money?
An earnest money deposit is an amount of money given to the seller by the buyer before closing that serves as a good faith payment to convey your seriousness of wanting to purchase the home. It has nothing to do with the lender or the financing of the home. Your real estate agent will facilitate your money transfer to the seller’s agent.
Most earnest money deposits are given as personal checks or cashier’s checks. Ensure you receive a copy of the payment you made and that it’s listed somewhere in writing, preferably on the offer contract. When you’re ready to sign a contract to make an offer, most earnest money deposits are given to the buyer. This shows that you’re making an honest, proactive effort to let them know you’re serious about buying the property.
If you change your mind about buying the home later, the owner can pocket the earnest money unless you negate a contract based on the reasons listed in your buyer’s contingencies. People who provide earnest money are much less likely to waste a seller’s time by backing out of a home sale.
Talk to your real estate agent about the buyer’s contingencies. If those contingencies aren’t listed clearly, you won’t be able to get your earnest money refunded if the contingencies aren’t met. Some examples include when you’re not able to secure a loan or if you find out it’ll cost too much money to repair a home in poor condition.
Schedule an inspection by a certified home inspector before making an offer on a home. The inspector can find any potential issues early and give you a thorough report about the property’s condition to help you make an informed decision. Unless you waive your contingencies, you could be eligible to receive your earnest money back if the home doesn’t pass inspection or has issues that make the sale price unreasonable.
How much do you put down for earnest money?
You may wonder how much you put down for earnest money when making an offer on a home. In most cases, the deposit is somewhere between 1% to 5% of the total asking price. However, this amount could be much higher in hot markets or for new construction homes. Some markets see buyers offering earnest money deposits of 10% or even more. If your area’s real estate market is booming, you may notice buyers trying to offer more earnest money to get ahead of the competition.
The sales contract indicates the amount of earnest money as well as all terms and conditions. Once the amount is agreed upon, this money is held in an escrow account.
Your sales contract should list all your contingencies to receive a refund of your earnest money. Typical contingencies include the buyer failing to get financed by a lender before the closing date, serious issues uncovered after a home inspection, the property doesn’t appraise to the lender’s standards, or problems being revealed later regarding the title of the home. Some other examples include medical emergencies or other events that could jeopardize your ability to be approved for a home mortgage. You can waive some or all of these common contingencies, but you’d lose your earnest money deposit whether you buy the home.
Here are two common questions about where your earnest money deposit goes:
- Does earnest money go towards a down payment? You may choose to put your earnest money deposit toward your down payment. Let’s say the home sells for $200,000, and you plan on putting 20% down, which is $40,000. If you pay 5% earnest money, you’ll give the seller $10,000 in the escrow account. This will reduce your total down payment to $30,000 when you’re ready to close on the home.
- Does earnest money go towards closing costs? Another scenario is that you may apply your earnest money deposit to your closing costs. If you made that same earnest money deposit of $10,000, you could put it toward various closing costs, including your agent’s commission, title fees, and more. Ultimately, it will be up to your lender and/or your real estate agent to plan how to use the earnest money and where it will go. Either way, it ends up with the seller in some shape or form.
What is a down payment?
The down payment is the amount of cash you’re planning to put toward purchasing your home. After you pay the down payment, you’ll finance the rest in the form of a home mortgage. The higher your down payment, the better your terms and conditions will be. Making a smaller down payment means you’ll pay more interest over time; in some cases, you may even need a co-signer to be approved. For many loans, down payments under a certain threshold mean the buyer must pay PMI or private mortgage insurance. Whenever possible, paying a 20% down payment or higher is the best way to get a good deal and avoid paying PMI.
Lenders look at several factors besides your credit score when applying for a home loan. One of these is your debt-to-income ratio, which is how much money you already owe (think student loans, car payments, and credit cards) compared to how much money you earn.
The lender will also look at the LTV or loan-to-value ratio of the property. The LTV indicates how much money you’ll owe on the home after you make the down payment. This figure is calculated by dividing the loan amount by the appraisal value or purchase price. Ideally, your LTV should be 80% or less. If you make a 20% down payment or higher, your LTV will reach that number or lower. The lower your LTV, the more options you’ll have for financing. Paying more upfront usually means you’ll pay less monthly when you make your mortgage payments. This frees up your cash for other things like retirement savings or home improvements and repairs later.
There are a few different types of home loans you can apply for that take the down payment size into account. Here are the two main categories of home loans to consider:
- Conventional loan: These home loans go through private lenders like banks or credit unions. If you can’t make a 20% or higher down payment, you’ll need to pay PMI. Keep in mind that once your home’s equity reaches 80%, you can request to have the PMI removed from the loan in writing.
- Government loan: These loans have many more rules and guidelines, but they also may allow you to pay as little as a 3.5% down payment. Most government loans already have PMI factored into them, but you can’t have it removed, even after you meet the equity threshold. VA, USDA, and FHA loans are the most common forms of government home loans, and they’re backed by the government rather than a private financial institution.
Is it worth it to pay a higher down payment?
You may wonder if it’s worth waiting and saving up for a higher down payment, and the answer is yes. The larger your down payment, the more money you’ll be able to save over the life of the loan. Don’t forget that if you pay 20% or more, you can also avoid paying for PMI, which only increases your mortgage payment. With a higher down payment, your monthly payments will be lower, and the loan will typically have a lower interest rate. Lenders take on less risk when borrowers are willing to provide more capital upfront.
It might take some time and patience to save for a sizeable down payment on a home, and you won’t see the benefits immediately. For some, having more cash on hand has more advantages than paying for a larger down payment. When you have more money in the bank, you’ll be able to deal with unexpected home repairs more easily, for example. This allows you to take care of essential issues without relying on credit.
The amount of your down payment will be paid directly to your lender on the closing date and given as a cashier’s check. This money will be presented on the day you close, predetermined in advance. Once you close, the lender pays the total cost of the home to the seller, you’ll get the keys, and the house is yours. You’ll already be ahead of the game if your down payment is higher.
Now that you know more about the difference between an earnest money deposit and a down payment go out and find your dream home.