As part of the home-buying process, you’ll need to come up with cash for a down payment (or earmark funds for one) and also earnest money. After all, a home is a big purchase, and you don’t want just anyone buying it.
Down payments and earnest money are a way to show that you’re a serious buyer, and they also help to protect the sellers in case you back out of the deal for some reason. However, these payments are often confused—so let’s set the record straight.
To help you avoid mistakes when buying a house, we’ll discuss earnest money, and down payments, how they differ, and answer frequently asked questions about each.
What is earnest money?
From the buyer’s perspective, the earnest money is like a good faith deposit. It’s a sum you agree to pay at the time of an offer to show that you’re serious about buying the home.
For example, let’s say you offer $300,000 for a home. You might also agree to pay $3,000 in earnest money along with your offer. If the seller accepts your offer, the earnest money goes into escrow, a bank account that a third party holds.
The funds are then used towards your down payment or closing costs at the time of closing.
Why do you have to pay earnest money?
In a seller’s market where there are more buyers than homes for sale, earnest money can give you an edge.
For example, let’s say two buyers make an offer on the same home. Both offers are for the same price, but one buyer has $5,000 in earnest money, and the other only has $500.
The seller is more likely to accept the offer with earnest money because it shows that the buyer is serious about buying the home.
In addition, earnest money protects sellers if a deal falls through. For example, let’s say a buyer agrees to purchase a home for $300,000 with a $3,000 earnest money deposit. The buyer then backs out of the deal for a reason that wasn’t outlined in the contract.
In this case, the earnest money protects the seller by compensating them for the time and effort spent on the deal.
What reasons can you lose your earnest money deposit?
In most cases, you’ll only lose your earnest money deposit if you:
- Back out of the deal without a valid reason
- Fail to get financing
- Don’t have a clean title
- Violate the terms of the contract
For example, let’s say you make an offer on a home, and the seller accepts. You then back out of the deal because you can’t get financing. In this case, you would lose your earnest money deposit because you violated the terms of the contract.
On the other hand, if you back out of the deal because the seller failed to disclose a material defect, you would get your earnest money deposit back.
What is a down payment?
On the other hand, a down payment is a sum of money you pay at closing to make up the difference between the purchase price and your mortgage loan.
For example, let’s say you’re buying a home for $300,000 and have a mortgage loan for $250,000. This means you’ll need to come up with $50,000 for the down payment.
Down payments are typically between 3% and 20% of the purchase price, depending on the type of mortgage loan you’re using.
Ways to come up with a down payment:
If you don’t have the cash on hand for a down payment, there are a few ways to come up with the funds. For example, you could:
- Borrow money from family or friends
- Get a personal loan
- Tap into your home equity
- Use a down payment assistance program
Because earnest money is typically a smaller amount of money than a down payment, it’s often easier to come up with the funds for earnest money.
For example, let’s say you’re buying a home for $300,000, and you need to come up with 3% for the down payment. This means you’ll need $9,000 for the down payment. If you’re also required to pay earnest money, you might only need to come up with 1% or $3,000.
Earnest money vs. Down payment: What’s the difference?
To be clear, the earnest money is not the same as a down payment. Here’s a quick overview of the main differences between earnest money and down payments:
- Earnest money is paid at the time of an offer, while the down payment is paid at closing.
- Earnest money is held in escrow until closing, while the down payment goes towards your mortgage loan. If the deal falls through, earnest money may be forfeited, while the down payment is always refunded.
- Earnest money only costs a few hundred to a few thousand dollars, while the down payment can be several thousand or even tens of thousands of dollars.
- You’re not required to have earnest money, but you will need a down payment to close on a home.
Earnest money vs. Down payment: FAQs
Q: Do you have to pay earnest money if you’re using a down payment?
Because earnest money and down payments are different things with different purposes, you typically have to pay both. While earnest money is not required, it’s typically expected in a competitive market.
Q: Can earnest money be used as a down payment?
No, you cannot use earnest money as a down payment. The earnest money deposit is typically a few hundred to a few thousand dollars and is paid upfront. The down payment is a much larger sum of money that’s due at closing. That said, your earnest money can be applied towards your down payment.
Q: Do you get earnest money back if the deal falls through?
It depends. You should get your earnest money back if the contract is terminated due to factors beyond your control (such as the seller’s inability to obtain financing). However, if you backed out of the deal for a reason not outlined in the contract, you may not be entitled to a refund.
Q: Can earnest money be used as a down payment on another home?
No, the earnest money is non-refundable and can only be used to purchase the home it was intended for. By contrast, your down payment will be refunded in full if you back out of a deal before closing.
Q: How is earnest money refunded?
If the deal falls through and it wasn’t because of something outlined in the contract, the earnest money should be refunded to you within a few weeks. The earnest money is typically held in escrow by either the title company or a real estate broker.
Q: Do you need earnest money for a pre-approval?
No, the earnest money is not required for a pre-approval. The earnest money is only paid once you’ve found a home and are ready to make an offer. So, while you don’t need earnest money for a pre-approval, you will need a down payment.
Q: Do first-time home buyers have to pay earnest money?
There’s no hard and fast rule, but earnest money is often expected from all buyers in a competitive market. So, while first-time home buyers don’t have to pay earnest money, they may have a harder time winning a bid if they’re not willing to put down earnest money.
Q: Can earnest money be paid in cash?
No, the earnest money is typically paid by personal check, certified check, or wire transfer. Cash is not typically accepted because it’s harder to track.
Many things go on behind the scenes of a home purchase, and earnest money is just one piece of the puzzle. While earnest money and down payments are two different things, they’re both important to understand before buying a home.
Make sure you’re clear on the earnest money requirements in your contract and don’t be afraid to ask questions if you’re unsure about anything. Check out things to consider when buying a new home to learn more.