Two terms common to the sale and purchase of real estate are “earnest money” and “down payment.” In this blog post, I will review the definitions of each of these terms and how they are used in the context of real estate and escrow.
What is Earnest Money?
According to Merriam-Webster, earnest money has various definitions, including:
- a serious and intent mental state
- something of value given by a buyer to a seller to bind a bargain
- a token of what is to come
Earnest money is exactly these things. In the purchase of an asset, it represents an advance deposit made by the purchaser toward the final purchase price. Earnest money establishes the purchaser’s intent to acquire, through the contribution of value as a “token of what is to come.” These dollars are frequently held by a third-party escrow agent, in trust, until conditions for release have been met.
Conditions for release of these funds are negotiated between the seller and purchaser, and the earnest money can be applied against the purchase price of the asset after certain conditions are met, such as:
- Completion of inspection(s) or testing
- Completions of due diligence
- Purchaser’s procurement of additional financing
The terms of the purchase or sale contract will determine whether the earnest money is refunded to the purchaser or retained by the seller. Ultimately, earnest money can effectively be used to protect both parties. If the purchaser is unable to fulfill certain contracted obligations, then the seller may retain the funds and avoid the burden of a settlement through the court system. On the flip side, the purchaser is protected and can get funds back if the seller terminates the agreement or if inspections or due diligence produce a failing event.
What is a Down Payment?
Back to Merriam-Webster for the definition of a down payment:
a part of the full price paid at the time of purchase or delivery with the balance to be paid later
A down payment differs from earnest money in that, in the case of a down payment, the purchaser and the seller have moved successfully through contracted requirements and have arrived at a lender requirement for the purchaser to place a certain amount of their own money toward the acquisition price of the asset.
Down payments can vary in amount, depending upon lender requirements and how much the purchaser can reasonably afford. As a general rule, the more the purchaser can apply as a down payment, the better, as the larger amount can make:
- the loan approval process easier,
- the amount of the loan smaller, and
- the resulting payments and interest costs lower.
While different, earnest money and down payments are a very important part of the sale and purchase process. As stated above, the more a purchaser can apply as earnest money or as a down payment, the better. Large earnest money deposits can encourage the seller toward temporarily taking the asset off the market and accepting the purchaser’s offer. In highly competitive scenarios, earnest money is a powerful tool for the purchaser. Down payments represent another powerful tool for the purchaser, as they indicate a strong commitment to the lender regarding shared risk in the investment.