Anyone who has ever purchased a home has interacted with these two terms, but strangely buyers report that they were not fully explained the difference between the terms during the process causing some unnecessary anxiety. When purchasing a home the numbers run larger than most people are used to in any other transaction, so it is important to know exactly what these terms mean. Let’s try and remove the mystery.
Deposit money is the amount a buyer pledges to provide in the writing of an offer to purchase when expressing interest in buying a property. Dating back to ancient Greek and Roman times, deposits of goods, coins, or clothing, were used to secure the goodwill of a seller after the negotiations had taken place in a public setting. This ensured that the buyer had witnesses to what the agreement was, and the seller had the security that the buyer would follow through on their end of the bargain, or risk the loss of that deposit and the public shame that came with the inability to fulfill their word.
In old English, the term “earnest money” was used to indicate that the buyer was making a payment “in earnest” or under commitment to complete the rest of the transaction and ultimately pay the full amount. Fast forward to modern times and the deposit that a buyer indicates they are bringing to the transaction remains an important step in establishing goodwill between the parties and demonstrating that the buyer has unencumbered capital to place into the deal.
The current AREA purchase contracts include terms of trust established by the parties to ensure that the deposit money given by the buyer is held in a trust account and only disbursed under certain circumstances agreed to beforehand by both the buyer and seller. It is important to understand that modern contracts normally include conditions that the buyer uses to ensure that the property is what they think it is, and that they can secure the financing they need to complete the transaction, and those conditions protect the buyer's deposit from being forfeited to the seller when the buyer does not remove those conditions. However, once the buyer waives those conditions and agrees to proceed with the transaction, the deposit forms part of the agreed purchase price which will be paid to the seller at the completion.
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The key thing to recognize about down payment money is that it is generally not related to the negotiation phase, but the financing phase of the total picture. Where Deposit money is placed as a type of promise to complete the transaction, the down payment is related to the amount of total liquid capital the purchaser has, or is willing to use, to facilitate the financing of the total purchase price. The total down payment a buyer agrees to provide, plus the amount of new financing through a mortgage makes up the total purchase price.
For example, if the buyer interested in a $200,000 home may decide to put up a 20% down payment and take 80% of the purchase price as a mortgage. That means in this example, they would need $40,000 of available capital such as cash or cashable investments to provide to the lawyer at the closing and the mortgage lender will provide the remaining $160,000 in exchange for registering a mortgage on the property. Here is where the deposit money comes into view. If the buyer in our example provided a deposit of $10,000 in the purchase contract, this $10,000 also forms part of the purchase price and is calculated as coming out of the total downpayment money not in addition to it, so they would need to bring only $30,000 to the lawyer for closing since they paid $10,000 into the transaction already.
A regular question REALTORS® often get from a buyer is “How much deposit should I put in the offer?”. This question comes from the desire to put as little as possible into the transaction while still demonstrating their serious interest in the property. I have always found that a good rule of thumb is to place about 3-5% of the purchase price as a deposit but the truth is that it comes down to whatever the buyer is comfortable offering and seller agrees to accept. If the deposit is not in jeopardy before conditions are removed, and forms part of the downpayment anyway after the removal of the conditions, a larger deposit does demonstrate the strength of the buyer buyers commitment to the trade.
The only caveat I would offer is if the initial deposit is large, and some part of the buyer's conditions, despite their best efforts, fails to meet expectations and the buyer decides to move on and find another property, it can take a couple of weeks to get the deposit money back out of the trust account. If the buyer used all their availble money on the deposit for that transaction it could slow down their ability to place a new deposit on a different property. In such cases, the AREA contracts anticipate the possibility of a smaller initial deposit and a larger additional deposit after condition removal to solve this possibility.
This treatise on the subject is really only touching the surface of the information available, not to mention the vast number of variables that present themselves in specific transactions. For this reason, every consumer needs the real-time advice of a REALTOR® to help them navigate the many options available to them in managing the deposit money in a purchase contract, and the advice of a licensed mortgage broker regarding the down payment.