Earnest Money Vs. Down Payment: Know The Difference
Written by Jason Nelson on July 5, 2017
Buying a home can be absolutely overwhelming, especially if you’ve never done it before. You may find yourself signing paperwork and writing checks without completely understanding what it’s all for. Because home buying is such a complex process, it’s important to do your best to know exactly what you’re committing yourself to every step of the way.
Two terms that can sometimes be confused during the home buying process are earnest money and a down payment. These two things are completely different so it’s important not to confuse them.
What’s a down payment?
If you’ve ever purchased an item using a loan, you’re likely familiar with what a down payment is. It’s simply a lump sum, typically a percentage of the total purchase price, that you put down on the item you’re purchasing. A down payment is essentially a non-refundable incentive to ensure that the borrower is fiscally invested in paying off their mortgage. Depending on the type of mortgage you’re seeking the percentage you’ll need to put down will vary, but if you want to avoid paying extra each month for mortgage insurance you’ll need to put down at least 20%. There are very few mortgages where a down payment is not required, and it’s usually best to put down as much as you can since this will help you to reduce the amount that you pay interest on in the long term.
How is earnest money different?
While your down payment goes directly to your lender, earnest money is actually intended for the seller of the home. Earnest money is essentially a prospective buyer putting their money where there mouth is. For a seller, this money ensures that the buyer is seriously interested in the property. This allows them to avoid wasting their time and money negotiating with someone who isn’t actually vested in the deal. Likewise, this money allows a buyer to feel that the seller is seriously considering their offer. Think of it as a security deposit confirming that both parties are serious about the transaction.
It’s important that you read the contract concerning earnest money carefully so that you know under what circumstances you would or would not regain access to this money. In many cases, the earnest money is forfeited to the seller in the event that the buyer backs out of the deal, as stipulated in the contract. If the buyer has abided by the rules laid out in the contract and the seller withdraws, often the money is returned to the buyer. If the purchase goes through, the money is typically applied to the down payment given to the lender. All of this will be dependent on your unique situation and the terms you agree to when you sign the contract. This is why it’s vital that you read through the earnest money contract carefully and ask questions to clarify anything you may not understand.
The key to a smooth home buying process is staying organized and always asking questions. A home is a substantial long term investment, so you need to make sure you understand exactly what you’re signing up for. If you have questions about your down payment or earnest money contract, feel free to contact one of our mortgage brokers and we’ll be happy to help.