We often encounter some confusion over the language used to describe the money advanced by the buyer when signing contracts for the purchase of a home. Sometimes a client will tell us that their loan does not call for a downpayment, but rather they are only giving earnest money. However, whether we call it a downpayment, or binder, or earnest money, or good faith deposit, there is no legal distinction. Its function, rather than its label, is what’s significant. There are two functions, and they’re both about how much skin in the game the buyer has.
At the time of Closing….
First, as to the buyer’s mortgage lender, the bank wants a degree of equity, or value of the home beyond the loan balance. And the reasons are two-fold. One, it’s human nature that a home would be taken better care of when the homeowner has a stake in it. If the homeowner has no value in the house beyond what is owed the bank, there is little incentive to maintain the home to maintain its value. Second, in the unlikely event of a default on the loan, the bank would have the right to foreclose against the house and get a Court’s approval to sell the home at public auction and apply the proceeds to the balance owed on the loan. So to tend to protect the lender for such an auction falling short of paying off the balance of the loan, the lender would require a minimum percentage of cash in from the buyer at the start of the loan. This percentage of cash required for the loan is often referred to as the downpayment. Some loans require 20%, some 3%, and some even allow NO downpayment at all. Usually any downpayment less than 20% will require PMI (private mortgage insurance) to be paid by the borrower which insures the lender if a foreclosure results in a loss to the lender. So as of the closing, the amount of the “downpayment” will be impacted by the type of loan the borrower is getting.
At the time of contract….
Second, the seller wants the purchaser to have a stake in the deal as of the signing of the contract. If there is no, or very minimal downpayment, the buyer can tie up the property for the seller for months, and the buyer can walk away from the deal with no consequence. So the downpayment paid ON CONTRACT is significant in holding the deal together, and motivating both parties to move forward, or risk financial pain. Also, a larger downpayment paid on contract can signal a stronger buyer, and a small downpayment a sign of questionable ability to close. Every deal is different of course, and there are many factors that go into determining the amount of a downpayment paid on contract. Generally, however, a downpayment of 5 or 10% is most customary.
Confusing downpayments with downpayments
Because the term “downpayment” is often used both by banks to describe how much cash in, or equity the buyer must have in the deal as of closing, AND the amount of money a buyer puts in escrow with the sellers’ attorney when they sign the contract, confusion can sometimes result.
On one end of the spectrum, just because a buyer is lucky enough to qualify for a VA or USDA loan that permits 100% financing and nothing down as of the closing does NOT mean the seller will go to contract with no downpayment. In those cases, a seller might indulge a lower than normal downpayment, but there has to be enough put down on contract to be painful if the buyer decided to just walk away from the deal without a right to.
On the other had, we are often presented with a situation where the buyer advises that their bank requires a 20% downpayment on their loan (as of closing), and the offer is mistakenly written up as if that full 20% is to be put down at contract. 20% would be double or quadruple what is customarily put down on contract, and would unnecessarily tie up the buyer’s funds, and even risk them if the buyer breached the contract.
The Bottom line…
Don’t confuse the two “downpayments” in a deal. They are not interchangeable. For the closing, the bank and the type of loan dictates how much money in the buyer must have when the dust settles. For the funds paid on contract, it can be higher or lower than the bank’s requirement, and is usually 5 or 10%. If we get it right from the beginning of the deal, we can enjoy a smoother transaction that reaches the finish line without the delays of unnecessary contract changes.