The difference between an earnest money deposit (EMD) and a down payment is that EMD is an advance provided to the seller to motivate them to accept an offer. The down payment is the money you pay upfront which will go towards the purchase of the home.
Both are important in the home buying process. The earnest money deposit assures the seller that you are serious about your offer, while the down payment assures the lender that you’re financially committed to buying the property.
Here is the inside scoop on Earnest money deposit vs. down payment.
What Is An Earnest Money Deposit?
The earnest money deposit, also known as good faith deposit, or simply, initial deposit, is money provided by the homebuyer to the seller as a way of showing the seriousness of the offer. It is like the buyer saying “I’m serious about my offer and here is a deposit to prove it”.
The exact definition of the word (deposit) is “money transferred to someone for safekeeping”. Thus the earnest money deposit is not a fee, but an incentive that can motivate the seller to accept your offer.
That’s similar to when you buy other assets, such as a car; a deposit is produced to the seller so that they can hold the property for you while you arrange financing to pay the seller in full. It has nothing to do with the down payment.
When is the EMD paid in real estate?
To pay the earnest money deposit, you can choose between either of the below two options:
You can pay it immediately after you make an offer.
You can agree to pay it within 24 hours after the offer is accepted by the seller.
Most buyers choose the second option. However, in a bidding war, every little edge counts, so you are strongly encouraged to present your earnest money deposit together with your offer.
The money is NOT to be paid to the seller directly, but to the real estate brokerage representing the seller; this way, the funds will be held the brokerage’s trust account until the day of closing when the deposit will be applied to cover the down payment and closing costs.
How Much Deposit Do You Need to Buy a House?
There is no set amount for how much initial deposit you should pay; it depends on how expensive the home is, and what kind of market you’re currently in (a buyer’s market or a seller’s market).
As a general rule, 2% – 5% of the home’s price is considered a reasonable earnest money deposit while anything less than 1% is considered too low.
So, if you are buying a home with a sale price of $500,000, anything less than $5,000 (1% of the sale price) is too low, and anything over $10,000 (2% of the sale price) would be appropriate.
Naturally, if there are competing buyers, the larger the earnest money deposit, the better chances you’ll have of getting your offer accepted.
During a seller’s market, for instance, many sellers will ask buyers to submit a check together with their offer for as much as 5% of the purchase price.
What Happens to the Deposit Money at Closing?
One of these three things will happen to your earnest money deposit:
If the deal goes as planned, the money will be applied towards your down payment.
In the event the deal is canceled because a contingency was not met, the money will be returned to you in full.
The seller may keep the money if the buyer pulls out of the deal without a reason that is allowed under the agreement to purchase the home.
As mentioned above, a “deposit” is an advanced payment that goes towards the purchase of an asset. The deposit is not a fee or money paid in addition to your down payment. Essentially, you’re pre-paying part of the purchase price, before completing the purchase.
That’s the way it works; the money will be held in an escrow/trust account, managed by the real estate brokerage representing the seller. On the closing day, the deposited amount is then applied as part of the buyer’s down payment or closing costs.
The lawyer or the representative handling the closing for you will provide you with a statement showing a breakdown of the fees and how much money you have to pay and deduct the earnest money deposit that you already paid.
So, how much is a typical earnest money deposit?
There is no set amount for the size of the deposit. The rule of thumb is to give an earnest money deposit that between 2% to 5% of the home’s list price.
In a seller’s market, the amount of the deposit tends to be higher and some sellers will request, right on the listing agreement, to bring a deposit of 5% of the offer price.
If you are in a multiple offers scenario, the bigger your earnest money deposit, the more likely you are to get the house.
Remember, this is a deposit that’s meant to tell seller that you mean “business”; it’s not a fee, so don’t overthink it. Instead, ask your agent how much deposit he/she recommends for explained earlier 2% – 5% is appropriate.
In a buyer’s market, sellers are less likely to demand 5% deposits on every offer, but the larger your earnest money deposit the more the seller would be enticed to accept your offer even if the purchase price is lower than other offers.
Is the earnest money deposit refundable to the buyer?
The earnest money is refundable. However, to get the deposit refunded, you must follow the rules as set out in the purchase agreement.
That’s because the agreement to purchase a home is legally binding contract, which means if you want to back out of the deal you must have a legal basis for doing so.
Having said that, there are two instances under which the buyer is allowed to get their deposit back.
If you (the buyer) submit a deposit together with your offer and the seller rejects the offer, then you get your deposit money back.
If you (the buyer) cancel the agreement before the conditions/contingencies have been satisfied, then you get your earnest money deposit back.
However, you will have to make sure to include contingencies with your offer; the most common contingencies are mortgage financing and a home inspection, but those contingencies will have an expiry date.
Once the expiry date lapses without you taking any action, it means the contingencies have been satisfied.
For example, if the contract says the home inspection must be conducted within the next 10 calendar days, the home inspection must be completed by the deadline or you risk losing your deposit money and being sued by the seller.
How to protect your earnest money deposit
Here are four ways how home buyers could protect their deposit:
Include condition/contingency for a home inspection in the contract. This gives you some time to have a professional home inspection done on the house; if you don’t like what you find out, you’ll be able to cancel the deal and get your deposit money refunded.
Include a home appraisal condition in the contract. When you apply for the mortgage, your lender will order an appraisal on the home to ensure that the amount you offered is on par with the market value. If the home does not appraise well, a home appraisal condition will allow you to cancel the deal and get your deposit back.
Include a mortgage financing condition in the contract. This condition will give you the time you need to secure a mortgage loan. If you don’t get approved, you can cancel the agreement and get your deposit back.
Don’t miss the deadlines. Make sure you abide by the terms and deadlines stated in the contract. As previously explained, once the expiry date of the contingency lapses, it’s now too late to back out of the agreement.
When Can the Buyer Lose the Earnest Money Deposit?
The purpose of a deposit (EMD) is to motivate home buyers and sellers to carry out the purchase and sale of a home with an element of good faith. If the buyer breaches the agreement, the deposit is forfeited to the seller.
Yes, the last thing a home buyer wants is to lose their deposit money, so it’s important to understand the ways how the deposit money could be lost.
Here are the two ways how a home buyer may lose their earnest money deposit (EMD):
When a buyer backs out of a contract without using a contingency as the reason for backing out, the buyer loses their deposit to the seller.
When a buyer makes an offer to purchase a home and does not include any condition/contingency, the seller accepts it, but later the buyer changes their mind and cancels the deal, the deposit is forfeited to the seller.
This is why you should always include contingencies with your offers; smart home buyers always give themselves an option B just in case something happens such as the financing doesn’t pan out, or the home inspection showing issues with the home, or simply because you changed your mind.
” Smart home buyers always give themselves a legal way out, and that comes in the form of a contingency clearly expressed within the purchase agreement. “
In normal circumstances, if the contingencies period has not lapsed and you decide you can’t go through with the purchase and you want your deposit (EMD) back, you (the buyer) and the seller will sign a release form that allows the real estate brokerage to refund you the deposit money from their trust account.
If the seller refuses to sign the release form, a judge could eventually rule via court order for the release of the funds.
Can a buyer get out of a deal by refusing to pay the earnest money deposit?
No. Once the deal is accepted and signed, you can’t change your mind; if you do, you’ll lose your deposit and may be sued by the seller. Your only option for backing out of a deal it to use one of the conditions/contingencies such as the home inspection as your basis for needing to cancel the agreement.
What Is A Down Payment?
A down payment is the amount of money the buyer pays upfront towards covering part of the purchase of the home; the remaining part is covered by the mortgage.
For instance, if you purchase a home for $650,000 and you put a down payment of $50,000, then your mortgage will be for $600,000.
Out of the $50,000 down payment, you will deduct the amount of the initial deposit (EMD); so if you initially gave a deposit for $20,000; that means you will need another $30,000 to complete the $50,000 down payment.
That’s the way it works, your deposit is like an advance that you will get to use towards the down payment.
Having a good down payment is a key first step in realizing your dream to purchase a home; the higher your down payment is, the better chances you’ll have of qualifying for a mortgage.
What is a good down payment on a house?
The amount of your down payment will depend on the price of the home and the lender’s requirement as it relates to the size of the loan you can be approved for.
Most lenders will require a minimum down payment of 5% of the home’s price, but the recommended amount is 20%. So if you’re putting down 5%, on a home that’s worth $600,000, you’ll need a minimum down payment of $30,000.
Some FHA loans allow you to buy a home with a down payment that’s as low as 3.5%.
For self-employed individuals or if you’re buying a rental/investment property, you’ll need a minimum of 10% down payment. Naturally, the higher your down payment is, the higher your chances of getting the following:
- A lower interest rate
- A smooth mortgage application process
- Getting approved for a higher mortgage amount
EMD vs. Down Payment: The bottom line
The key difference between earnest money deposit (EMD) and a down payment is that EMD is money produced to the seller to convince them that you’re serious about your offer. On closing day, this money will become part of your down payment.
With the earnest money deposit, you are saying to the seller “I am committed to buying your home, and here is the money to prove it”
The down payment, on the other hand, is money you produce to the lender to show that you are financially fit to be approved for a mortgage loan.
With the down payment, you are saying to the lender “I am financially fit to be approved for a mortgage, and here are my savings to prove it”
In its’ simplest form, earnest money deposit is a promise to the seller, while the down payment is a promise to the lender; so they are different, but both are important in the home buying process.
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