Navigating the home buying process can be tricky, whether you’re searching for your dream home or preparing your home to be sold.
Two standard terms of equal importance to both the buyer and seller are “earnest money deposit” and “down payment.” Both have to do with money, but what is the difference between them?
Earnest Money Deposit vs. Down Payment
What is an earnest money deposit?
An earnest money deposit is a good-faith gesture on behalf of the buyer proving their commitment to purchasing the seller’s property.
How much is required for a typical earnest money deposit?
Most often, the amount of an earnest money deposit is 1%-5% of the purchase price; however, this amount may vary based on the state you live in, the current real estate market, as well as the buyer’s method of financing.
Earnest money deposits are typically due when the purchase contract is first executed, often in the form of a personal check. The money is held by either the buyer’s agent, title company, etc. and is never given to the seller directly. If the check is deposited, then the funds will be held in what is known as an escrow deposit account and will be credited towards the purchase price of the property at closing.
Depending on the wording of the purchase contract, a seller may be entitled to keep a buyer’s earnest money deposit, should the buyer fail to close on the property due to a number of reasons – simply deciding not to purchase the property, waiver of contingencies or failure to secure financing within the timeframe agreed upon in the purchase contract.
While an earnest money deposit functions as a promise to the seller, a down payment is a promise to the lender facilitating your mortgage loan.
What is a down payment?
A down payment refers to the amount of money a buyer pays to the seller at closing, via a cashier’s check or wired directly from the buyer’s bank. Most often, the money for a down payment is derived from either the buyer’s savings, proceeds from the sale of a current home, or a gift from a family member.
How much is required for a typical down payment?
The lender often determines the exact amount needed for a down payment in relation to the overall loan amount; however, a 20% down payment is recommended by real estate agents. According to experts at NerdWallet, “A larger down payment offers advantages beyond lowering the monthly mortgage payment and avoiding PMI. You’ll also get a lower mortgage interest rate, pay fewer fees and gain equity in your home faster” (NerdWallet.com).
Keep in mind that in addition to saving for a down payment, you will need to budget for closing costs and other expenses when purchasing a home.
It’s important to connect with a local lender that understands the real estate market in your community, as well as your personal financial goals. At GoPrime Mortgage, Inc., our local lenders will guide you every through every step of the home buying process. After all, it’s more than just a mortgage – We’re connecting families with their dream homes! Find a local lender near you here: //ow.ly/V2MV50xZs6w.
In today’s housing market, making sure your offer on a home will stand out is important. There are a few ways to let a seller know you’re serious about buying a home, such as a preapproval from a lender, or the Rocket Mortgage® Verified Approval program. Another option is putting down an earnest money deposit.
This article will provide an overview of what earnest money is, how to use it to your advantage when buying a house and how to protect yourself once you deposit it.
What Is Earnest Money In Real Estate?
Earnest money is put down before closing on a house to show you're serious about purchasing. It's also known as a good faith deposit.
When a buyer and seller enter into a purchase agreement, the seller takes the home off the market while the transaction moves through the entire process to closing. If the deal falls through, the seller has to relist the home and start all over again, which could result in a big financial hit.
Earnest money protects the seller if the buyer backs out. It's typically around 1 – 3% of the sale price and is held in an escrow account until the deal is complete. The exact amount depends on what's customary in your market. If all goes smoothly, the earnest money is applied to the buyer's down payment or closing costs.
If the deal falls through due to a failed home inspection or any other contingencies listed in the contract, the buyer gets their earnest money back. The practice of depositing earnest money can decrease the likelihood of a buyer placing offers for multiple homes, then walking away after the seller takes the home off the market.
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Example: Earnest Money In Practice
Alex, Taylor and Sam are all selling their homes. Charlie is a home buyer who has looked at all three houses and wants one of them, but can't quite decide which one. If all three sellers require earnest money deposits, there are three scenarios that can play out with Charlie’s home purchase.
Situation A: The Forfeited Deposit
Charlie doesn't want to decide on a single house just yet and makes a good faith deposit on all three houses. Alex, Taylor and Sam each take their homes off the market and inform their other potential buyers that Charlie wants the house.
Later, Charlie decides to buy Alex’s house. Taylor and Sam now have to put their homes back on the market and start looking for buyers all over again. Luckily, Charlie’s earnest deposits are Taylor’s and Sam’s to keep. This offers them some compensation for the time and money they lost due to Charlie backing out of the sales.
Situation B: The Early Closing Payment
Charlie doesn't have money to spare on making deposits to all three sellers, and after some consideration, decides on Alex’s house and makes a single deposit. Everything goes to plan, Charlie moves in and the deposit goes toward paying off the house.
Situation C: The Failed Contingency
Charlie makes a single deposit to Alex, but after the home inspection, discovers the house is infested with cockroaches. Luckily, Charlie has a home inspection contingency in the purchase agreement and decides not to buy and gets the deposit back from Alex.
Why Should You Pay Earnest Money?
Earnest money isn't always a requirement, but it could be a necessity if you're shopping in a competitive real estate market. Sellers tend to favor these good faith deposits because they want to ensure that the sale won't fall through. Earnest money can act as added insurance for both parties in the transaction.
Earnest money could also lower the amount you need at closing because it's applied directly to your down payment or closing costs. Essentially, you're just putting up some of the money earlier in the process.
How Verified Approval Could Help
Rocket Mortgage’s Verified Approval can give you even more of a leg up on the competition by assuring the seller that you can qualify for the loan you need. A seller looking at multiple offers is more likely to lean toward a buyer with approved funding – and having earnest money down on top of it can make your offer stand out even more.
How Much Earnest Money Is Enough?
The amount of earnest money you should offer depends on the particular real estate market your desired property is in. A languishing real estate listing in a slow market may not need as much earnest money as in a hot market with multiple buyers who are vying for the same property. If you plan to purchase in a neighborhood where cash offers and bidding wars are common, a higher good faith deposit is a good idea.
If you're working with a real estate agent, they should be able to provide direction on how much earnest money you should offer. If you're competing with others for the same property, it's in your best interest not to undercut the earnest money deposit amount because you could lose the home to a stronger offer. If it's a slow or moderate market, your agent can advise you if a good faith deposit in the standard range will suffice.
Is Earnest Money Refundable?
Earnest money has contingencies that protect both the seller and buyer in certain situations.
When you make an offer on a home and the seller accepts, the sale is only finalized when contingencies, or certain criteria, are met. They're typically listed in the purchase agreement and cover the inspection, appraisal and mortgage approval, among other items.
Home Inspection Contingency
The home inspection is a common reason potential buyers back away from a deal. If your prospective home is inspected by a professional and some elements of the home come back in need of repair, a home inspection contingency can allow you to back out of the transaction. If you don't want to back out of the deal, you could also work with the seller to have the repairs made or have them lower the purchase price so you can do the repairs yourself.
Appraisal Contingency
The appraisal contingency, which protects the buyer if the property is overvalued, is equally important. The lender hires a third-party appraiser to determine the fair market value of the home and to compare it to similar properties for sale. With this contingency, if the home is appraised at less than the sale price, you can choose not to move forward with the deal and you'll get your earnest money back. Alternatively, you can use the appraisal to negotiate a new price.
Financing Contingency
If you weren't preapproved for a mortgage when you put your earnest money deposit down – or even if you were – and then you don't get approved, a mortgage contingency can protect you. You have the right to walk away and get your earnest money back as long as this contingency was listed in the agreement.
Contingency For Selling An Existing Home
Some contracts also include a contingency for selling your existing home. If you can't sell the home you currently own before you close on another home, this contingency lets you back out of the deal with your earnest money in hand.
When To Waive A Contingency
In hot real estate markets, some buyers feel pressure to waive contingencies; for instance, they may consider this if they're absolutely certain they'll qualify for a mortgage. However, it's never a good idea to waive the appraisal or inspection contingencies. Those contingencies are there to protect you.
How to Protect Your Earnest Deposit
There are a few steps you can take to protect your earnest money:
Step 1. Use An Escrow Account
The real estate market isn't immune to fraud. As a result, you should never give your earnest money directly to the seller or a real estate brokerage. Instead, go with a third party such as a title or escrow company, which will hold your earnest money for you.
You'll usually pay by certified check, wire transfer or personal check. Your check should be made out to that third party, and you can keep a copy of the check and request a receipt. The funds are then held in the escrow account until closing.
Step 2. Know Your Contingencies
Contingencies are in place to protect both the seller and buyer, so you should understand every scenario where you and the seller can back out and what impact that would have on your earnest money. Be sure you're comfortable with the contingencies and are confident any actions you take won't result in losing your good faith deposit.
Step 3. Stay On Track With Your Responsibilities
To protect the seller, the purchase agreement will typically include a timeline for when every aspect of the process has to be met, such as the date by which you need an inspection done or when the mortgage should be approved.
If you miss those deadlines, there could be grounds for the seller to back out of the deal with your earnest money in hand. Most sellers won't rescind the deal the minute you miss a deadline, but if you take too long, it could be a deal breaker.
Step 4. Put It All In Writing
A home is one of the largest purchases many of us will make. It's important to protect your investments along the way, which is why you should put everything in writing. This includes any changes to the timeline and buyer responsibilities. Make sure the purchase agreement lays out who gets the earnest money if the contract is canceled.
For instance, if the inspection fails and the buyer will get to keep the earnest money, state that in the contract. If the buyer has a change of heart and the seller will keep the earnest money, lay that out as well. Everything should be explained in detail in the contract.
The Bottom Line
Earnest money can protect a home buyer if something is wrong with a property, and also the seller if you simply want out of the deal. Going the extra mile with a Verified Approval or an earnest money deposit can also prove to a seller that you're serious about your offer, making your offer stand out from other buyers.
Ready to begin the home buying process? Apply online today for mortgage approval from Rocket Mortgage.