When buying a home, you may come across the terms “earnest money” and “down payment.” What’s the difference between the two?
Earnest money is a deposit you make when you’re under contract to buy a home. It shows the seller that you’re serious about the purchase. The earnest money you’ll need to put down varies by buyer and seller but is typically 1-3% of the home’s purchase price.
The down payment is the final portion of your home’s purchase price you’ll pay at closing. The amount you’ll need for your down payment will depend on several factors, such as the type of mortgage you’re getting and the amount you’re borrowing.
The earnest money is generally paid upfront, while the down payment is paid at closing. Sometimes no earnest money is required… and sometimes, a huge deposit is required.
But the most important aspect—you might not get earnest money back.
How Does an Earnest Money Deposit Work?
Now that we know the basics of an earnest money deposit let’s discuss how it works.
When you make an offer on a home, your real estate agent will help you write up a purchase contract. This contract will include several important details, such as the purchase price, the closing date, and any contingencies that must be met before the sale is final.
The contract will also specify the earnest money you’ll need to pay. As mentioned, this deposit is typically 1-3% of the home’s purchase price, but in very hot markets, it can be a lot more. Earnest money is a good-faith deposit showing that you’re serious about buying real estate.
If you buy a $400,000 house, your earnest money deposit could be $12,000 or more. And that’s a lot of money to put up before a transaction is completed.
Therefore, you should only make an offer on real estate that you’re truly serious about purchasing.
Once your offer is accepted, you’ll need to write a check for the earnest money and deliver it to either an agent or directly to the title company. The diligence money will typically be held in escrow until closing.
At closing, the earnest money, sometimes called a diligence fee, will be applied to your down payment or used to pay other closing costs, such as title insurance or loan origination fees.
Sometimes, you may get your earnest money back if the deal falls through. But this isn’t always the case. If the deal falls through because of you, or if you decide to walk away, you forfeit your earnest money.
Can You Get Your Earnest Money Back?
Sometimes, you can get your earnest money back if the deal falls through. But it all depends on the situation. The home buyer is generally at a disadvantage in a seller’s market.
If you’re backing out of the deal because you’ve changed your mind or can’t meet the contingencies in the contract, you will not get your earnest money back.
If you’re backing out of the deal because the home inspection revealed serious issues or if the appraisal came in low, then you may be able to get your earnest money back. It all comes down to the contract. So read it carefully before making an offer on a home.
Today, a lot of buyers are making a lot of concessions. If you waive your home inspection contingency, for instance, you can’t get your earnest money back if issues are revealed during the inspection. That’s because the contract is no longer contingent on the home inspection.
Not every buyer understands this when they make their offer, and they are surprised when they don’t get their earnest money back.
Why Do You Need to Offer Earnest Money?
In a competitive housing market, you must offer earnest money to show you’re serious about buying the home. If you make an offer without earnest money, the seller may not take your offer seriously. After all, what’s to stop you from backing out of the deal?
But if you put down earnest money, it shows that you’re committed to following through. When a seller stops accepting other offers and a deal falls through, it can hurt them financially.
That being said, you don’t need to offer earnest money. It isn’t a requirement. In lower-cost transactions, it’s possible that your real estate agent won’t offer earnest money at all. It depends on how solid your offer already is and what the conditions are in the market.
How Much Earnest Money Should You Offer?
The amount of earnest money you offer depends on a few different factors.
First, consider the market conditions. In a hot market, where homes are selling quickly, and there’s a lot of competition, you’ll need to offer more earnest money to stand out from other buyers.
Second, consider what could go wrong in the transaction. If there’s a good chance that the deal could fall through, you’ll want to offer less earnest money. For instance, if you’re waiving quite a few contingencies, you’re increasing the chances that you might need to walk away from the deal.
And finally, consider your financial situation. You don’t want to put down more money than you’re comfortable with. There are a lot of things that could potentially go wrong that could leave you without that money.
So, how much earnest money should you offer? As a general rule of thumb, you should aim to decrease 1% of the purchase price. So, if you’re buying a home for $200,000, your earnest money would be $2,000.
Can the Seller Keep Your Earnest Money?
Now, you know a seller should return your earnest money if the deal falls through, and you aren’t at fault.
But realistically, is it possible that a seller keeps your earnest money?
It’s rare, but it does happen. In most cases, it happens because the seller has financial difficulties and needs the money. For instance, they discover they need to repair their property and see your money as an easy win.
But that’s why you generally deliver your earnest money to the title company, not directly to the seller. What happens to the earnest money will be spelled out in your purchase contract, which you can show to your title company.
It is dangerous to waive every contingency and offer a large earnest deposit. If you do this, you virtually guarantee you will lose your earnest money if you back out of the purchase agreement.
What Is a Down Payment?
Now that we’ve covered earnest money, let’s discuss the down payment. Most people are more familiar with the concept of a down payment than earnest money.
A down payment is the final portion of your home’s purchase price you’ll pay at closing. When you close on your home loan, you pay your down payment.
For example, if you’re taking out a conventional loan to buy a $400,000 house, you’ll need to make a down payment of at least 10% (usually, there are some exceptions). So, you’ll have to come up with at least $40,000.
If you’re taking out an FHA loan, on the other hand, you can get away with a down payment of as little as 3.5%.
Your down payment and all the other closing costs aren’t due until closing. You must either wire your down payment to the escrow company or bring it as a cashier’s check. So, there’s a significant gap between when you pay your earnest money and your down payment.
Your earnest money is applied to your down payment and other closing costs, so it isn’t lost or spent as long as you don’t walk away from the offer.
Conclusion: Earnest Money vs Down Payment
Now you know the difference between earnest money and a down payment. Earnest money is paid upfront, while the down payment is paid at closing. Earnest money will be applied to your down payment and closing costs, but you may forfeit earnest money if you walk away from the transaction.
In a competitive market, offering earnest money shows you’re serious about buying the home. But it can also be dangerous because it’s money that you could lose if you change your mind.
Earnest money is a good-faith deposit that shows you’re serious about buying a home. In a competitive market, offering earnest money to show you’re committed to the deal is common. If the deal falls through on your side, you forfeit the earnest money. If the deal falls through on the seller’s side, you should get your earnest money refunded.
Most sellers won’t accept an offer without some amount of earnest money. Earnest money gives your offer more weight. It shows that you’re serious about buying the home and have the funds to do so. Sellers will be skeptical of an individual who isn’t willing to put at least some money down