What Is the Difference Between Earnest Money and Down Payment?
Gain clarity on two distinct financial steps in your home buying process. Understand their roles to confidently secure your property.
Purchasing a home involves various financial terms and monetary commitments. Understanding these components is important for anyone entering the housing market. This article clarifies two such components: earnest money and down payments, outlining their roles and implications in a real estate transaction.
Understanding Earnest Money
Earnest money is a deposit made by a buyer to demonstrate serious intent to purchase a property. This “good faith” deposit signals to the seller that the buyer is committed to the transaction and is not making a frivolous offer. Typically, the amount ranges from 1% to 3% of the home’s sale price, though in competitive markets, it can be as high as 10%. The specific amount is often negotiated between the buyer and seller.
Once agreed upon, the earnest money is usually paid shortly after the purchase contract is signed or attached to the offer. These funds are not given directly to the seller. Instead, a neutral third party, such as a title company, escrow company, or real estate attorney, holds the money in an escrow account until the transaction closes. This arrangement ensures the funds are secure and disbursed appropriately based on the contract’s terms.
The primary purpose of earnest money is to secure the contract during the contingency period, allowing the buyer time to conduct due diligence like inspections and appraisals. Buyers can generally get their earnest money back if certain conditions, known as contingencies, are not met. Common contingencies include the home inspection revealing significant issues, the appraisal coming in lower than the agreed-upon price, or the buyer being unable to secure financing. However, if a buyer backs out for a reason not covered by a contingency or misses contractual deadlines, the earnest money may be forfeited to the seller as compensation for taking the property off the market.
Understanding the Down Payment
The down payment represents the portion of the home’s purchase price that the buyer pays upfront, directly reducing the amount of the mortgage loan needed. This payment is a direct contribution towards the purchase price, not a deposit, and it immediately establishes the buyer’s equity in the property. The size of the down payment can influence the terms of the mortgage loan, including the interest rate and whether private mortgage insurance (PMI) is required.
The median down payment for all homebuyers in the U.S. was around 18%, while first-time homebuyers typically put down a median of 9%. The percentage required varies based on the type of loan obtained. Conventional loans often require a minimum down payment of 3% for fixed-rate loans, though many lenders may prefer 5% or more. If a down payment of less than 20% is made on a conventional loan, borrowers typically pay private mortgage insurance (PMI) to protect the lender.
Federal Housing Administration (FHA) loans, which are government-insured, offer flexible down payment options. They typically require a minimum of 3.5% for borrowers with a credit score of 580 or higher. If the credit score is between 500 and 579, a 10% down payment is generally required for an FHA loan.
For eligible military service members, veterans, and surviving spouses, VA loans, backed by the U.S. Department of Veterans Affairs, often do not require any down payment, allowing for 100% financing. Making a down payment on a VA loan can still be beneficial, for example, by reducing the VA funding fee.
Key Distinctions and Interplay
Earnest money and the down payment serve distinct roles in a real estate transaction. Earnest money demonstrates a buyer’s serious intent and secures the contract, acting as a good-faith deposit. In contrast, the down payment is the initial equity contribution towards the home’s purchase price, directly reducing the loan amount needed.
The timing of these payments differs. Earnest money is typically paid when the purchase offer is accepted or soon after the contract is signed, usually held in an escrow account. The down payment, a much larger sum, is paid at the closing of the transaction. Earnest money is conditionally refundable based on contingencies outlined in the contract, while the down payment is generally not refundable once applied to the purchase at closing.
A common point of interaction is that earnest money is usually credited towards the down payment or closing costs at closing. For example, if a buyer makes a $5,000 earnest money deposit on a home requiring a $30,000 down payment, the buyer would then bring the remaining $25,000 for the down payment at closing. This means the initial earnest money contributes to the buyer’s overall financial obligation but is not the entire down payment. The earnest money, held by a neutral third party, is applied as part of the total funds due from the buyer at closing.