Buying a home is always an exciting event. Going through the purchase process, however, can often be stressful and time consuming. The various types of payments required are probably the most confusing part for most home buyers. For example, say you’ve been pre-approved by a lender and committed to the down payment you will make on your new home — but now you’re being asked to put down an earnest money deposit. In this article, we’ll explain exactly what earnest money is and how it’s different from your down payment.
What Is Earnest Money?
Once you’ve found your perfect home, you should be prepared to come up with some cash to secure it. The initial payment you make when you sign a purchase contract for a home is known as earnest money. As the name implies, its purpose is to show that you are acting in good faith and are serious about purchasing the home.
Once you make an offer on a home and the offer is accepted by the seller, the latter has to take the home off the market. That involves risk. If you should change your mind or find a home you like better and walk away from the contract, the seller would incur both an inconvenience and a financial loss. The earnest money deposit serves to protect the seller and provide him or her with financial compensation should the contract be broken.
The typical amount of the earnest money deposit is 1% to 3% of the purchase price. This amount can vary, however, depending on the location, the real estate market and whether you are buying a resale or a new construction home.
In a sluggish real estate market, you may be able to negotiate the amount of earnest money, while in a hot market you may choose to offer a higher than requested amount to get an edge over other potential buyers.
Typical practices for earnest money deposits on new construction are quite different. When a home builder invests in building a new home for you, he assumes greater risks and therefore seeks more protections. The typical new construction deposit is 5% to 10% of the purchase price. If the buyer is paying all cash for the home, the earnest money deposit is usually higher. Most new home builders will allow the buyer to personalize the home to be built with specific options and upgrades. That further increases the risks for the builder should the contract be broken, and therefore an additional deposit is required on options and upgrades. That deposit typically ranges from 25% to 50%.
Is Earnest Money Refundable?
Naturally, as a buyer you want some protections when putting down a sizable chunk of cash before taking possession of your new home. Those protections are written into the purchase contract as contingencies. They specify the circumstances under which your earnest money deposit is refundable. Those usually include:
- Issues found during the inspection of the house: As a buyer you have the choice of canceling the contract and receiving your earnest money back if the issue is a deal breaker for you; asking the seller to rectify the issue within a set amount of time; or asking for a concession to compensate you for the problem.
- Low appraisal: If the house does not appraise for at least the selling price, the buyer has the option to cancel the contract and be reimbursed for the earnest money deposit or to request a price reduction.
- Denial of or delay in home financing: While these days it’s expected for the home buyer to obtain pre-approval from a lender prior to making an offer, a pre-approval is still not a guarantee of mortgage loan going through. If the buyer is not approved for financing, he or she can receive the earnest money deposit back.
If the sale does not go through for a reason not specified in a contingency clause, the seller gets to keep the deposit. Therefore, it is extremely important for the home buyer to make sure all the circumstances that may require the cancellation of the contract and refund of earnest money are written into the contract as contingencies.
A new construction home purchase agreement will contain fewer contingencies, but the buyer can still be reimbursed for the earnest money deposit in case of a denial of financing within the specified time frame.
Earnest Money vs. Down Payment
The two terms are often confused. They are not the same but are closely related. The earnest money deposit can be viewed as part of the down payment. While an earnest money deposit functions as a promise to the seller, a down payment is a promise to the lender providing your mortgage loan.
Earnest money is a financial commitment signaling the buyer’s serious intent to purchase a home. The earnest money deposit is never given to the seller directly. It is usually put in an escrow account by a third party, such as the title company, and held until the closing date. At the closing the earnest money is applied toward the down payment or closing costs.
Down payment is the cash payment the buyer puts down on the home purchase. The rest of the purchase price is usually financed, unless the buyer makes an all-cash purchase, in which case the balance is paid at closing by a certified check or wire transfer. The amount of down payment varies, typically from 3% to 20% or more, depending on the type of loan and a number of other considerations.
- Conventional loans require a minimum of a 3% down payment; however, it’s common to put down 20%. The 20% down payment is a magic number that eliminates the need for private mortgage insurance (PMI). The PMI serves to protect the lender in case of a loan default. Thus a 20% down payment decreases the monthly payment and eliminates an extra charge. Home buyers putting down 20% may also qualify for a more favorable interest rate on their mortgage. Coming up with a 20% down payment can be unrealistic for many, particularly first-time home buyers. Depending on your situation, you may choose an amount between 3% and 20%, as long as you can qualify to finance the balance.
- FHA (Federal Housing Administration) loans require a 3.5% down payment, making them attractive for some buyers; the downside of them, however, is that the mortgage insurance premiums are higher than on conventional loans, adding to the cost of monthly payments.
- VA (Veterans Administration) loans do not require a down payment or mortgage insurance and thus are an attractive choice for active or retired members of the military.
Does Earnest Money Go Towards Down Payment?
The earnest money paid at contract is applied towards the down payment and/or closing costs at closing. So, it’s the money you pay upfront on the purchase of a home, but it’s not in addition to the down payment. One should keep in mind, however, that the down payment is not the only cash required to purchase a home. Buyers also need to plan on having cash to cover extra expenses such as an appraisal, title search, potentially an independent inspection, and all or part of the closing costs.
The down payment is paid directly to the seller as part of the money disbursement process at the closing. The remainder of the purchase price is paid to the seller by the mortgage company and assumed as a mortgage loan by the buyer.