Homebuyers must make two large payments when purchasing a house. One is the earnest money paid upon execution of the sales contract. The second is the down payment to the lender at closing. What are the differences between the two?
It’s all about commitment. In both cases, these payments represent a commitment to the purchase. Earnest money shows that the buyer is making a serious offer to the seller. It can be refunded only under very specific and legitimate circumstances.
Down payment money is paid as part of the lending process. It is paid by the buyer — with the rest of the purchase price being paid by the mortgage company. The larger the down payment, the higher the commitment level from the buyer toward the purchase.
How earnest money works. When a buyer and seller sign a sales contract, the buyer writes a check to the seller’s broker, or an escrow or title company, depending on what is customary in your area. The earnest money, typically between 1 percent and 3 percent of the sales price, varies by state and is negotiable. The money is held in an escrow trust account until the deal closes. The earnest money is refundable only if certain terms of the contract are not met, such as the buyer not being approved for a mortgage. If all goes well and the deal proceeds to closing, the earnest money is credited to the buyer.
How down payments work. After the contract is signed and earnest money paid, the buyer has a time period specified in the contract to obtain a mortgage. The amount required for down payment depends on the type of loan. Several government-backed loans, such as Federal Housing Administration (FHA) program loans, are available for as little as 3 percent down. In some cases, the Veterans Administration guaranteed-loan program offers loans with nothing down. Most conventional (non-government backed) loans will require a larger down payment since a lender is bearing the risk. If buyers put down 20 percent or more, the mortgage company considers the loan at a low risk for default. For buyers who put down less than 20 percent, the lender will require private mortgage insurance (PMI), which protects against buyer default. The monthly premiums are paid by buyers as part of their mortgage payments.
Both earnest money and the down payment are separate from other closing costs that buyers must pay as part of the purchase process. At closing the amount of earnest money paid upon execution of the sales contract is credited as part of the down payment money from the buyer.