Any real estate transaction is filled with lingo and unfamiliar terms. Two that are commonly not known or misunderstood are the Earnest Money Deposit and the downpayment. Allow us to explain the difference between the Earnest Money Deposit vs. down payment and why each is important.
The Earnest Money Deposit (EMD)
An Earnest Money Deposit is an amount of money that buyers put forward — into an escrow account — when submitting an offer on a home. The purpose of the EMD is for the buyers to show the seller that they are in good faith, or “earnest,” about buying the house (in other words, the buyers aren’t writing a contract without intending to follow through on the purchase). The EMD also serves as security for the buyer that the seller will not sell the home to anyone else while they are under contract.
Earnest money deposits usually range from one to three percent of the purchase price of a home. So if you’re purchasing a $500,000 home, the EMD would range from $5,000 to $15,000. To strengthen an offer, a purchaser can provide a larger EMD.
EMD money does NOT go directly to the seller; rather, the funds are held in an escrow account. They appear as a credit to the buyer at closing and offset part of the down payment amount or closing costs.
What’s the benefit of the EMD? For the seller, the EMD provides protection against a buyer backing out of the deal. The seller may (these laws vary by state) be able to keep EMD money if the buyer pulls out of the deal — if it’s for a reason not outlined in the purchase contract. The most common scenario is the buyers simply changing their minds after ratifying the contract. For buyers, a large earnest money deposit could set you apart from the competition, which may be helpful in a hot market.
The Down Payment
A down payment is an amount of money a home buyer puts towards the purchase of the home, which the seller receives. The remainder of the home’s purchase price comes from a home loan (mortgage). The minimum down payment required by mortgage lenders is three percent of a home’s purchase price. A 20 percent down payment (or more) is best if possible for a variety of reasons. Typically, the higher the down payment, the better the buyer’s chances of getting approved for a mortgage. Plus, buyers will then have the added bonus of smaller monthly mortgage payments.
Down payments can come from savings, equity from another home, or another source (check with your lender for guidelines) For more on how to save for a down payment, read our related post. Down payments usually come in the form of certified funds. The buyers bring the funds to the closing or their bank will wire them directly. Down payments often include the earnest money deposit, credited back to the buyers at closing.
It’s important to note here that if a down payment is less than 20 percent, buyers will likely have to purchase private mortgage insurance (PMI). This insurance mitigates the default risk on your loan. Mortgage insurance runs about one percent of your loan amount (or $1,000 per year per $100,000).
The Bottom Line
The EMD and the downpayment are both very important components of any real estate transaction. The only way buyers lose their EMD is if they were to pull out of a deal for a reason not outlined in the contract. While the EMD can go towards closing costs, it often becomes part of the buyers’ down payment. The amount of a down payment can vary widely but it’s best to put down 20 percent whenever possible to avoid having to pay for mortgage insurance.
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