Earnest money Vs. Down payment: What Is the difference?

Money is the most constant element in the home-buying process. As a homebuyer, you must part with some money, from the first step of house hunting to closing the deal. That means you must prepare financially and understand all the minor home-purchasing costs, including down payment and earnest Money.

You may have heard of down payment and earnest money in most real estate conversations. However, do you know the difference between the two payments and why they are essential in home-buying? 

While both terms may mean initial payments made by the buyer, they serve different purposes, as discussed herein.

What is earnest money?

Earnest money or a good faith deposit is the amount a homebuyer pays to the seller or deposits into the escrow account once their offer is accepted. The buyer deposits the money to show the seller they are interested in the house and willing to reach the closing table. Also, although earnest money is not a significant requirement in the real estate transaction, it gives the seller more incentive to consider the buyer's offer. That means the more good faith deposits, the higher the chances of winning the offer and showing that you are serious.

How Much Is Earnest Money?

Earnest money usually falls between 4% and 5% of the home's asking price. However, depending on the buyer-seller agreement, the amount can rise to 7-10% in a competitive market. Sellers in hot or upcoming neighbourhoods can also ask for more than 10% of the home's price as earnest money to win high-budget buyers.

Earnest money can also be refundable or non-refundable, depending on several factors. For instance, if the sale falls through because of contingencies listed in the contract, the buyer may receive the good faith deposit back. But in most transactions, the earnest money is directed to the closing costs when finalizing the deal.

What Is a Down Payment?

A down payment is the upfront cash the buyer pays for the home purchase. After paying the down payment, the buyer can finance the remaining amount using a home mortgage. In most cases, the amount of money a buyer pays as a down payment acts as an assurance to the lender or mortgage facility that the borrower can pay the loan. Therefore, a higher down payment gives the buyer better mortgage terms and lower monthly premiums.

Unlike earnest money, where a seller can negotiate the percentage, the mortgage facility determines the percentage a buyer pays as a down payment. For instance, the minimum down payment for a home worth less than $500,000 is 5% of the home price, while the minimum down payment for a home worth over one million dollars is 20%. That means buyers going for high-value homes will pay more as upfront cash.

Key Difference Between Earnest Money and Down Payment

Earnest money and down payment are vital payments that help secure a deal. Most sellers consider buyers with more earnest money when accepting offers. On the other hand, most lenders consider buyers with more upfront cash when pre-approving them for a mortgage.

However, these two payments have their key differences based on the following factors:

1. Where The Money Goes

Earnest money goes to an escrow account until the deal is closed. Although the seller considers the money the buyer's commitment, they only have access to it at the end of the transaction. This allows a third party to keep the money safe for the buyer or release it to pay closing costs.

Regarding the down payment, the buyer pays the cash directly to the buyer's lawyer when finalizing the deal. In rare cases, the down payment can also go directly to the seller's lender if they still owe money on their mortgage.

2. The Purposes of The Money

A good faith deposit starts the escrow process for the two parties. It is also used as security and stays in the escrow account for the entire negotiation period until the closing date. Once the deal closes, the money can finally be released to the buyer's lawyer, who then transfers funds to the seller's lawyer.  

Down payment, on the other hand, goes directly to the home purchase. The money pays part of the home's price, while the loan finances the rest. Also, unlike the earnest money that the buyer pays at the beginning of the process, the down payment comes at the end after the two parties agree on the price and sign the contract.

3. How Much the Buyer Pays

Earnest money ranges between 4% and 5% of the home's value in most markets. However, depending on various factors, the amount can go up to 10% of the property value. It is also vital to note that there is no standard amount that a buyer has to pay as earnest money or a forced requirement to do so. Therefore, a buyer can decide to deposit more money to save for the closing costs or provide a promissory note.

On the contrary, a buyer has to pay a minimum of 20% of the home's price as a down payment when buying a home. The amount can drop or rise depending on the buyer's credit score, debt-to-income ratio, and loan-to-value ratio. However, unlike a good-faith deposit, the buyer can only pay a down payment lower than the lender's set value if they have private mortgage insurance (PMI).

The Bottom Line

Buying a home comes with many boxes that a buyer has to check. Starting from the down payment and closing costs to earnest money, these aspects can overwhelm new homebuyers. Therefore, as a keen housing market investor, you should strive to understand the critical differences between these significant payments before entering into any home purchase deal.