I have clients who have a hard time understanding the difference between these two terms, so I thought that I would share the below excerpt which makes it easy to understand. I know that I had a hard time too before I became a Realtor, so don't worry if you're confused by some of the definitions used in the world of buying and selling properties.
Earnest money shows the seller that a buyer is serious—in other words, “earnest” in their intention to purchase the house. The point of the earnest deposit is to stop would-be buyers from making offers on multiple houses they’re interested in, which would result in all of those properties temporarily taken off the market until the buyer commits to one of them. For this reason, it’s unusual for a seller to entertain an offer on their house without it being backed up by a deposit that a buyer could lose. If the sale proceeds successfully, the earnest money can be used for the down payment or the closing costs of the sale. It can be looked at by buyers as putting aside some funds to cover part of these later costs.
How Much Should a Buyer Offer in Earnest Money?
Typically the deposit required by a buyer will be between 1% and 5% of the purchase price. There are a few factors that can affect this, however, including the state of the real estate market and what the seller requests as a deposit. A higher deposit can be required if there is a lot of demand in the local market, but on the other hand, a low deposit might be accepted if there isn’t much demand. Also, the customs around earnest money vary from state to state. Sometimes it’s recommended that you put down a higher deposit if it might lead to an offer being accepted. Higher deposits could also lead to the seller being more flexible on other terms in the offer.
What Happens to the Earnest Money Deposit?
You need to understand that when an offer has been accepted, a purchase agreement for the house will be executed. This agreement should state who is going to be holding the deposit. This will normally be the title company or the seller’s real estate agency, who will keep it in their escrow account. The earnest money will be accounted for at the time of the closing.
How Do Earnest Money and a Down Payment Differ?
Quite often, buyers get confused about the difference between earnest money and a down payment. While they both contribute to the purchase price of the house, the earnest money is security for the seller, while a down payment is money a buyer has to put towards the purchase price. The balance of a buyer’s funds for purchasing a house will come from the procurement of a mortgage.
Is It Possible to Get an Earnest Money Deposit Back?
There are many situations that will allow purchasers to get their earnest money deposits back. When things go wrong, and the deal falls through, buyers should be able to get their money back most of the time.
There should be contingencies in the contract to allow for situations where you can walk away with your deposit. If problems are found during the home inspection, you can choose to cancel the offer, renegotiate the price, or have the seller rectify the problem before you proceed. If you are not able to proceed with the sale because you cannot get the financing, you also would be able to get the earnest money returned.
Can You Lose Your Earnest Money Deposit?
You can forfeit your earnest money when you don’t pay attention to the terms of the contract. Here are the most common ways you can lose your deposit:
· You don’t respond in writing for extensions that you have in the contract, such as a home inspection or financing.
· You get cold feet and just walk away from the sale.
· You find another property that you like better and don’t proceed.
· You decide to put up a nonrefundable deposit to make your offer more attractive to the seller.
The bottom line is purchasing a home involves a lot of money so you need to work with someone like me who will keep everything as safe as can be!
Source: excerpt from Realtor Magazine