Buying a home requires you to understand many different real estate terms, two of which are earnest money and down payment. Both of these terms refer to payments that are made before the purchase of the home goes through, which is why there’s a considerable amount of confusion about these terms among potential homeowners.
Once you’ve identified a home that fits your budget and meets your needs, it’s essential that you indicate to the seller that you’re serious about the offer you’ve made and want to go through with the purchase. Even though the earnest money deposit and down payment are both able to show how committed you are to the purchase, they have entirely different functions.
When you make a high earnest money deposit, your offer will likely be more competitive for the seller. Higher down payments allow you to reduce your monthly mortgage payment and indicate to the lender that you’re not a financial risk.
Once the closing process occurs, all of these funds will be sent to the right parties. For instance, the earnest money deposit will be applied to your down payment. The down payment will be sent to your lender. In this guide, you’ll learn about the differences between earnest money and a down payment.
Is Earnest Money Different From Down Payments?
Earnest money is much different than a down payment. It’s considered a good faith deposit that you pay to the escrow account once your offer has been accepted. The payment tells the seller that you’re willing to go through the lengthy closing process. Down payments represent a percentage of the purchase price, which is paid at closing to effectively finance the purchase of the home.
Earnest money deposits are usually around 1-3% of the sale price. If the market is highly competitive, the earnest money deposit can be upwards of 7-10%. The amount that you make on a down payment depends on lender requirements as well as what you want your interest rate to be. A down payment typically ranges from 3-20% of the sale price. Making a higher down payment can help you obtain a lower interest rate, which results in a lower monthly mortgage payment as well.
What is Earnest Money?
Earnest money refers to a deposit that’s paid into an escrow account when finalizing a deal. Sellers can receive numerous offers in a short span of time, some of which aren’t made by serious buyers.
To avoid having to place their home back on the market, most sellers immediately discard offers that don’t provide a sizable amount of earnest money. Even though paying an earnest money deposit isn’t a requirement for the majority of real estate transactions, it provides the seller with more incentive to choose your offer.
If ever a buyer wants to avoid providing the seller with earnest money, they can instead offer a promissory note. These notes are considered letters of intent that indicate to the seller that the buyer is strongly interested in going through with the transaction. While promissory notes are sometimes effective, many sellers view them as less credible than earnest money deposits since no cash is involved.
Keep in mind that earnest money can be refundable and non-refundable depending on different scenarios. In most cases, these funds will go to the closing costs as well as any other expenses that must be paid when finalizing this deal. It’s possible, however, for the deposit to be given back to the buyer.
If the sale falls through because of a poor inspection or another issue that the buyer has, the buyer would likely be able to have the deposit returned to them. However, contingencies must be placed in the contract to make sure a refund of the earnest money deposit is possible.
What is a Down Payment?
A down payment is an upfront cash payment that represents a certain percentage of the home’s purchase price. In California, down payments typically range from 3-20%. Different types of mortgages have different requirements on what the minimum down payment needs to be. Even if your financial situation is strong, a down payment is needed to reduce the risk that the lender takes on when providing you with the loan.
Any money you spend on a down payment won’t be given back to you since it’s a portion of the final payment that the seller receives. These payments are made on closing day. If you don’t have the money at this time, the transaction can’t be completed.
Down payments and earnest money deposits are advantageous because they make it easier for the buyer to go through with a real estate transaction. While earnest money deposits allow your offer to stand out among sellers, a down payment gives you the means to finalize the transaction and make sure that the property is yours.
The Main Differences
There are three primary differences between earnest money and down payments, which include what the money is used for, who the money goes to, and how much you have to pay.
What Is the Money Used For?
A primary difference between down payments and earnest money involves what the money is used for. Earnest money is needed to start the escrow process for buyers and sellers. The money you place into the escrow account will be part of the funds that are given once the transaction comes to a close. Down payments are only applied to the complete purchase of a home and are never used to pay for anything else.
Who Does the Money Go To?
Earnest money deposits and down payments end up going to different places. Any money that you provide as an earnest payment will be placed directly into an escrow account and will be kept in there until the account is closed. Once these funds are provided, a third party holds them in a safe place until they can be applied to other expenses.
Down payment money always goes to the seller of the property when the deal is closed on. If the seller still owes money on their mortgage, it’s possible that the down payment will be sent to the seller’s lender.
How Much Do I Have to Pay?
There isn’t a strict amount that needs to be paid for either of these terms. Keep in mind, however, that there are some standard ranges that people usually pay when buying a home. As mentioned previously, the usual earnest money deposit in California is anywhere from 1-3% of the purchase price.
In comparison, down payments can amount to anywhere from 3-25% of the purchase price. When you’re trying to determine how large your down payment should be, take into account the amount of interest you’ll be expected to pay. Making a higher down payment reduces the amount of money you owe on the property and helps you obtain lower interest rates from a lender, which means that your monthly mortgage payment would be lower.
The Escrow Process
Purchasing a home with earnest money and down payments in California requires an escrow account. Escrow can be used for two separate reasons in real estate transactions. This account provides the buyer’s good faith deposit with protection, which ensures that it’s paid to the right party when the conditions of the sale have been met. This account also holds some of the homeowner’s money to be paid annually for homeowners insurance and property taxes.
Since there are two separate functions that escrow has, there are two types of escrow accounts that can be made. The first account is opened when you’re buying a home. In many cases, the first account will transition to the second account once the buyer takes ownership of the home. The account will remain open for the life of the loan.
When buying a home, the escrow account acts as protection for the seller and buyer by keeping the money in a location that’s maintained by a third party. Eventually, the seller will receive these funds. In the meantime, the money will remain in the account until closing or the deal falls apart. If you get to closing day, the earnest money deposit is applied directly to the down payment.
There are times when the earnest money deposit will remain in escrow past the sale of the home, which is known as escrow holdback. An escrow holdback could be necessary for several reasons. For instance, if the seller wants to remain in the home for an additional month after the closing date, an escrow holdback will occur. You could also discover that something’s wrong with the home during the last walkthrough, which is when an escrow holdback could be used.
The process of buying a home comes with many moving parts. Along with the down payment you make, you’ll also need to provide the seller with an earnest money deposit if you want them to take your offer seriously. Even though these payments differ, they are both needed before you can close on the transaction.