What's the Difference Between Earnest Money and a Down Payment?

During the home buying process, buyers will encounter terms that they may have heard of but, aren't familiar with, earnest money and down payment are two such terms. Both terms are regarding money but, what is the difference between earnest money and a down payment?

Earnest Money 

Earnest money is a deposit that a buyer makes to a seller to reflect that they are serious about purchasing the seller's home, it is considered a good-faith deposit. The earnest money deposit will compensate the seller should the buyer breach the contract or fail to close.

When the sales contract or purchase agreement is first signed is when a buyer will submit a check for the earnest money deposit. Once the earnest money is provided, the check will be held by the buyer's agent, title company, or a third party; it is never given directly to the seller. The check is sometimes never even cashed.

There are occasions when the earnest money check is cashed, the funds are held in an escrow deposit account. At closing, the money will show as a credit to the buyer and will offset the closing cost or down payment.

The purpose of the earnest money deposit is to show the seller that the buyer is committed to purchasing their home. There are types that a buyer will back out of the deal for one reason or another. What's the Difference between Earnest Money and a Down Payment? Depending on the reason for the buyer not continuing with the sale will determine if the seller keeps the deposit.

For example, the buyer did not have their loan approved, the seller will keep the earnest money deposit. If the inspection completed after the paperwork was signed shows expensive repairs that were not previously disclosed and the seller has no intention of making the repairs, the buyer will usually have the deposit check returned to them.

Earnest Money Deposit Amount

Earnest money deposits are not a requirement when buying a home, it's ultimately up to the buyer if and how much money they plan to put in an earnest money deposit.

Discussing the earnest money deposit with your real estate professional can help you decide if an earnest money deposit is necessary and how much they suggest a buyer puts in their earnest money deposit. The earnest money deposit can make your offer stand out above others, so when the market is competitive, a buyer should strongly consider making an earnest money deposit.

Typically, when an earnest money deposit is made, the payment ranges from 1% to 3% of the sales price. Again, this type of deposit is not required but, recommended and the amount doesn't need to be a set amount.

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Down Payment

A down payment is the upfront amount that a buyer pays directly to the seller not the lender, the down payment going to the lender is a common misconception.

The down payment is commonly the remaining amount the buyers will have to pay out of pocket to complete the transaction due to financing options that are available to them. The down payment is not returned to the buyer, it is necessary to go towards the sellers list price.

Down Payment Amount

The typical down payment amount is usually dependent on the lender and the overall loan amount. Mortgage lenders require a minimum down payment amount of 3% of the home price and a 20% down payment is recommended by real estate agents.

Most down payments usually range between 5% up to 25% of the total listed home value. While 20% has been the historical "magic number" in home buying, it is not realistic for homebuyers to have that much money in hand, especially first-time home buyers.

If a home buyer is unable to put at least 20% down, there may be a downside. Most lenders will require home buyers with a down payment less than 20% to pay for mortgage insurance. The mortgage insurance will mitigate the risk that you might default on your loan. It is an extra monthly fee, approximately 1% of your entire loan, so it can be pricey.

Related: How to Get a Home Loan Without Tax Returns

Summary

In summary, the earnest money deposit is completed in the beginning of the home buying process and is meant to make your offer stand out over others and lock down the deal for the buyer. The down payment helps finalize the deal at the end of the home buying process to ensure that the property is in the hands of the buyer.

The ultimate goal for both earnest money deposit and down payment is for the buyer to end up with the property they are interested in.