Let’s take a look at a hypothetical scenario: Mr. James has just made an earnest money deposit for a property he loves in California. In his mind, he is ready to close the deal. But when he gets to the bank, he is surprised that they are still requesting a down payment. “I thought the earnest money deposit is the same as the down payment,” he protests.
When it comes to closing real estate deals, many investors, like Mr. James, are often confused about the difference between earnest money deposits and down payments. This confusion often leads them to underestimate how much money they need to close a deal or what they need to pay at what time.
As the commercial real estate industry continues to blossom in the US, investors who want to close more deals and create a profitable portfolio must understand these two common terms, including their similarities and differences.
In this article, we will consider earnest money deposits vs down payments and how both of them are important when it comes to closing a real estate deal. We’ll cover:
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Today, there are many prospective property buyers on the market requesting information about properties, which has compelled some sellers to introduce a method of differentiating the serious prospects from the rest: the earnest money deposit.
Also known as good faith deposit, good faith money, and earnest deposit, this is an amount that the seller (directly or through a real estate agent) requests a potential buyer pay to show commitment and seriousness towards the purchase of a given property. Without this payment, commercial property or home inspection and negotiation might not be scheduled.
Earnest money deposits are now as common in the residential home buying process as in commercial real estate. Even when the seller does not request it, buyers often propose to pay it as a way of showing commitment and to get an edge over other candidates for the property.
Typically, sellers demand an earnest money deposit of between 5% and 15% of the property’s sale price, though many require as low as between 1%-3%. There is no industry standard and the amount of earnest money demanded will depend on the seller.
Though the earnest money deposit is made upfront at the beginning of the transaction, the seller typically doesn't take possession of it. Instead, the money is deposited in an escrow – a third-party account that holds the money on behalf of the two parties.
After this deposit has been made, the seller and buyer prepare and sign a purchase and sale agreement that will include terms upon which the deal will be finalized.
However, the payment of a soft deposit only confers on the buyer an option to buy rather than an obligation. That is, the presence of certain contingencies might necessitate that the buyer opt out of the deal.
If such contingencies were already included in the purchase and sale agreement (which is different from the purchase contract signed when the deal has been closed and payment made), then the escrow returns the earnest money deposit back to the buyer.
If, on the other hand, the reasons for voiding the deal are not part of already-agreed contingencies, the buyer will be required to forfeit the earnest money deposit.
Similarly, the seller might decide not to proceed with the sale even after the payment of the soft deposit money due to contingencies already included in the purchase and sale agreement (which is different from the sales contract signed when the deal has been closed and payment made). In this case, the soft deposit money will be returned to the buyer.
Earnest money is usually paid out in one of two ways.
First, it can be included as part of the down payment for the property (see below for what a down payment is). That is, if an earnest money deposit of $10,000 has been paid and the down payment is $1,000,000, the buyer will now be required to pay $990,000 instead of $1,000,000.
Secondly, the soft deposit can be used to cover all or part of the closing costs of the deal. According to Investopedia, “closing costs are the expenses over and above the property's price that buyers and sellers usually incur to complete a real estate transaction. Those costs may include loan origination fees, discount points, appraisal fees, title searches, title insurance, surveys, taxes, deed recording fees, and credit report charges.”
A down payment is a portion of the purchase price of a property that the lender demands from the borrower in a mortgage transaction.
The first thing to note is that a down payment becomes relevant only when the buyer of a property is not paying cash and using a mortgage instead. Though payment for properties with a mortgage is most common, there are still many people that pay cash.
In a mortgage transaction, the down payment serves various purposes. First, it is a way for the lender to be sure that the borrower has the capacity to make consequent payments. Second, it is a way for the lender to reduce its risk (by reducing the amount it needs to lend the borrower). Third, it is also a way for the borrower to get better loan terms (more on that below).
The down payment amount demanded by lenders can vary from between 5%-20% of the purchase price of the property.
In the US, 20% has been the traditional standard. Even when less than 20% is required, buyers prefer to pay as high as that since a higher down payment can procure better loan terms – lower interest rates, lower monthly mortgage payments, waiver of private mortgage insurance (PMI).
The down payment is used immediately to reduce the loan amount – the portion of the purchase price the lender needs to advance to the borrower.
For example, if the purchase price is $10 million and the borrower has made a down payment of $2 million (20% of purchase price), then the lender only needs to lend them $8 million. This is the amount that the purchaser will spread out over the following years, based on the terms of the mortgage.
Furthermore, the down payment goes directly to the seller of the property.
Down payment for a property is largely non-refundable if the deal is unsuccessful because of the purchaser. At the point of securing a mortgage and making a down payment, the buyer must have been fully convinced of their interest in the property. “It’s not uncommon that, in the event that the buyer is unable or unwilling to finalise the order, the down payment is not refundable,” adds Sum Up, a point-of-sale and invoicing company. “If the buyer cancels for any reason, the down payment might not be returned.”
In this case, many buyers prefer to continue with the process and then refinance the mortgage later on.
The main similarity between the two is that they are both important in the closing of real estate deals, even if they serve different purposes.
An earnest money deposit is important to get the inspection and negotiation process underway, while the down payment is essential in closing the deal with a mortgage loan.
Second, though how much earnest money and down payment required depend on the seller and mortgage lender, respectively, the amount may be very similar. There are deals that require earnest money of between 1% and 5% of the purchase price just as some mortgage deals (though rare) will be comfortable with a 3%-5% down payment.
Similarly, some deals can require between 5% to 15% for soft deposit, while many mortgage deals require between 5% to 20% of the property’s purchase price, with 20% being the traditional standard in the US.
Now, to the differences.
One difference between earnest money and down payments is the stage of the deal where they are required.
While soft deposit money plays a role at the very beginning of the sales conversation – before inspection and negotiation – a down payment is required once the deal has been finalized, terms have been agreed upon, and initial payment is required.
Sellers demand earnest money as a show of commitment so that negotiation and inspection (personal checks of the property) can proceed.
On the other hand, it is mortgage lenders that demand a down payment as evidence that the buyer has the financial wherewithal to service the mortgage loan.
Earnest money can be applied to the closing costs of the deal or the down payment. That is, it can be used as credit to pay closing costs or for down payment.
In contrast, the down payment is only used to reduce the amount the buyer needs to borrow from the mortgage lender to close the deal.
Not all sellers require earnest money – even if some buyers may still insist on paying it to gain a competitive advantage.
Conversely, all mortgage deals require some amount of down payment.
Similarly, while earnest money can apply to all real estate deals (whether paid for by cash or mortgage financing), down payment only applies to real estate deals financed with commercial property or home loans (mortgage).
Earnest money is usually held in an escrow account until it’s time to close the deal, at which point it can be used to pay closing costs or applied to the down payment.
On the other hand, the down payment is owned and controlled by the seller as soon as it is paid.
Another difference between earnest money and a down payment is refundability.
Earnest money only grants the buyer an option to buy. Consequently, the buyer can be refunded if they refuse to go on with the deal due to previously agreed contingencies.
In contrast, the down payment is non-refundable if the purchaser is the reason the deal fell through.
Due to personal or general economic conditions, many real estate investors sometimes struggle to come up with the cash needed for earnest money and down payments.
Does it then mean that such investors are cut off from the commercial real estate market?
Not necessarily. Regarding down payment, there are many creative ways to buy commercial property with no money down (including rent-to-own, seller financing, seller-provided down payment, etc.). Also, there are other ways to finance a commercial property outside of a conventional mortgage loan that might require less down payments (including SBA and FHA loan).
What about earnest money? You can use a conventional loan from a bank or the different forms of financing provided by online lenders to raise the cash for it.
However, soft deposit financing is often the most accessible option. Unlike banks, companies providing soft deposit financing do not require credit reports or inquire about credit scores. Also, the application process is streamlined and funds are quickly released into an escrow account, usually in less than 2 days.
Compared to online lenders, providers of soft deposit financing charge low financing fees, do not impose onerous terms on borrowers, and do not need to resort to unconventional methods to recover loans.
These benefits are procured because soft deposit financing involves a simple process that transfers money straight to an escrow account. Consequently, lenders can recover the funds from the escrow account if the buyer decides not to follow through with the transaction. In this case, the potential buyer is only liable for the financing fee unlike with traditional loans and online loans where the money borrowed cannot be returned.
Also, the buyer who wishes to proceed with the deal can only take control of the LLC created for the purpose of the earnest money and the purchase agreement when the money has been repaid to the lender. By thus minimizing their risk exposure, soft deposit financing companies can charge low fees, quickly disburse fees, and waive credit reports.
Duckfund is a leading soft deposit financing company in the US that provides commercial real estate investors with earnest money within 48 hours. The application process can be completed within 2 minutes and no credit report is needed. Duckfund charges only 2% monthly commision on all its soft deposit loans and there are no hidden fees lurking behind.
Furthermore, Duckfund can provide soft deposit loans for multiple deals at the same time. With this, real estate investors can pursue their interest in multiple deals and create a winning portfolio of commercial real estate even when they are lacking liquidity.
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