It’s easy to confuse your deposit with your down payment, especially if you’re buying a house for the first time. But although both are substantial sums of money and must be in your budget along with the cost of home insurance, they are different and distinct.
Renters are no stranger to deposits. When you sign a lease on a new apartment, your new landlord will ask you for a security deposit. Often this deposit is in the form of paying your last month’s rent, even though you may not know when that is. It shows you’re serious about renting the unit, and you’ll get the money back as long as you treat the apartment well and meet all the conditions of your lease.
Purchasing a home also requires a deposit, but it’s a little different than the one you pay a landlord. When you find a house and make an offer on it, you’ll make a deposit on it. Like the landlord, you want the seller to know you’re serious. But unlike the deposit you make on an apartment, you’re not going to get it back. Instead, it goes toward your down payment. This deposit is required when you write an offer to purchase a property with your real estate agent.
This deposit doesn’t immediately go to the seller, however. As the successful bidder on the property, your deposit should be held in trust by the real estate brokerage of the seller’s agent. In the rare and extreme case that you have a dispute with the seller, they can hold onto your deposit or keep it as damages, but they can’t just take the money and run. These deposits usually take the form of certified cheques, bank drafts and money orders, although soon you may be able to pay it through an electronic transfer — on your mobile device, no less.
Just like your last month’s rent, your deposit as the successful buyer of the home will accumulate interest, provided it’s written into the Agreement of Purchase and Sale. But unlike the deposit on an apartment, the size is a lot bigger. Most buyers will want to make a deposit that’s at least 5% of the purchase price as it tells the seller your finances are in order. In general, the deposit amount is guided by the purchase price as well as how quickly you’ll be closing the deal.
When the sale does close, this deposit will be applied against the total purchase price and becomes part of the down payment. In most cases, your deposit is lost if the sale doesn’t close, although offers that have conditions attached, such as the need for a property to pass a home inspection, can be exceptions that would see a deposit returned to you. But you if make an offer and change your mind about purchasing the house, not only will you likely lose your deposit, you could also face a potential lawsuit for any damages suffered by the seller.
The Down Payment
If you thought the deposit was a large lump sum, wait until you make the down payment — it’s going to be at least the same amount, but ideally, you’ll want to pay more than 5%.
The down payment is paid the day the sale of the house closes, and for most first-time home buyers, it represents years of tight budgeting and saving. Like the deposit, it should be at least 5% of the purchase price, but the more you can put down the better.
It’s rare for first-time buyers to be able to buy a new house outright, and your down payment will offset what your mortgage will be. Mortgage lenders will also want to know the source of your down payment. But while 5% is the minimum down payment to finance a home with a mortgage, the more you can pay the better — 20% is ideal for a conventional mortgage. Otherwise, your mortgage may be pegged as high-ratio, and you may have to pay mortgage insurance premiums.
The Mortgage Insurance
If you can’t make a down payment of at least 20%, mortgage default insurance is mandatory. In Canada, there are two private-sector providers, but most new home buyers will likely think of the insurance offered by the Canada Mortgage and Housing Corporation (CMHC).
This insurance protects lenders — typically, the bank that provides you with the mortgage — in the event you stop making payments and default on that mortgage. As a homebuyer, this insurance will cost you anywhere between 2.8% and 4% of your total mortgage amount. Although it does add to the overall amount you pay for your home, it allows people who can’t save the 20% down payment to access to the real estate market and keeps mortgage rates low by reducing the overall rates of default.
Regardless of whether you’re able to make the 20% down payment and avoid the need for mortgage insurance, this transaction and your deposit are probably the biggest sums of money you’ll give anyone in your lifetime. It’s essential to understand the difference and your obligations to everyone involved in the purchase of your first home.