While the words earnest money, also known as a buyer’s deposit or “good faith money,” and down payment are often used interchangeably among potential buyers, there are a few key differences. Both of these real estate terms are important for homebuyers to understand before diving into the housing market.
They both require a substantial amount of money but differ primarily by what stage they are required in the buyer’s home purchase and the amount of money needed.
A buyer’s deposit can be due when the offer is made, accepted, or another agreed-upon time, such as two days after all conditions have been removed. While both the deposit and down payment funds require a buyer’s cash savings, they occur at different times in the transaction. Timing-wise the deposit comes before the downpayment. Keep reading to learn all about a buyer’s deposit, downpayment funds, and key differences between these two commonly used terms.
A buyer’s deposit exists to protect the home seller and shows the seller that the buyer will, in “good faith,” go thru with the home purchase. Depending on how it is written in the purchase agreement, the deposit is usually due once the offer is firm and all conditions have been removed.
A buyer’s deposit can also be called earnest money or a good faith deposit. The size of the buyer’s deposit may be a good indication of how serious a buyer is about completing the home purchase. While a deposit is not necessary for the contract of purchase and sale to be binding, a seller should be wary of accepting an offer without a deposit.
Especially in a competitive market, a seller may negotiate for a higher deposit. Additionally, in hot real estate markets, a prospective buyer may attach a deposit to the offer to make their offer more attractive to the seller.
The buyer’s deposit is held by a third party (almost always the buyer’s agent’s brokerage) until the completion date when the deposit is released and forms part of the buyer’s downpayment amount. In some cases, the deposit can also be held by the seller’s agent’s trust account or a lawyer’s trust account, but that is quite rare. Should the buyer not complete the home purchase, the seller would be entitled to the deposit and may also pursue legal action against the buyer.
A buyer can pay their deposit by bank draft or wire transfer and some brokerages may accept personal cheques. The deposit is held in a trust account until the real estate transaction closes and the real estate lawyers or notaries disburse the funds. On closing day, your deposit goes towards your closing costs and down payment.
The deposit amount is usually about 3-5% of the purchase price but varies depending on how competitive the market is. A strong deposit shows the seller that you are a serious buyer who is motivated and committed to purchasing their property. A larger deposit amount protects the seller should you decide not to complete the purchase.
A strong deposit also proves to the seller that the buyer has the financial ability to purchase their property and is comfortable with some level of risk since the buyer will have “skin in the game.” Since deposits are usually between 3-5% (and sometimes more!), it’s a lot of money for a buyer to walk away from without a valid reason. A strong deposit is a good indication that the buyer won’t have a change of heart before closing day.
A downpayment is a sum of money that represents a percentage of the purchase price of the home. The minimum down payment can be anywhere from 5% to 20% of the purchase price in Canada. It will help if you meet with your mortgage broker early on in the home search process, as your available downpayment amount will influence your pre-approved loan amount.
A downpayment is required when purchasing a home because it assures a mortgage lender that you’re less likely to default on your loan. The available funds that you have for your downpayment, as well as your employment or business income, debts, and credit score, are just a few of the factors that will influence the size of your mortgage home loan.
If you can put down more money for your downpayment, then your monthly interest payments will be lower for the remainder of your loan because more of your monthly mortgage payments will go towards the principal.
The deposit occurs first, and then the downpayment is due at closing. Both the deposit and downpayment will go towards the purchase price. The deposit amount can vary depending on your local market and market conditions. The buyer and seller can negotiate the deposit and when it is payable, depending on how it’s written and agreed to in the terms of the contract.
In a seller’s market where there are more buyers than the supply of listings, a seller may negotiate a higher deposit. In comparison, the downpayment amount is determined by your financial situation, interest rates, and a lender’s requirements to qualify for a mortgage loan.
For example, say a home has a purchase price of $750,000. If the buyer can put down 20% of the purchase price as a downpayment, the amount would be $150,000. If you chose to include a 5% deposit on the same home, then your deposit amount (due at acceptance or after subject removals) would be $37,500. That deposit amount then goes towards your downpayment on closing.
The short answer is no, but you should meet with your mortgage broker to understand how much you should have available for your downpayment.
It’s important to note that if you have less than 20% as a downpayment, you will need to have private mortgage insurance. When a buyer has less than 20% of the home’s sale price as a downpayment, mortgage default insurance is mandatory. Private mortgage insurance protects mortgage lenders in case you can no longer make your mortgage payments and, as a result, default on your loan.
Mortgage insurance payments can be significant, so you’ll want to discuss the options with your mortgage broker.
Another advantage of a larger downpayment is that most of your monthly mortgage payment will go towards principal instead of interest. For example, if you can afford to put 20% as a down payment instead of 5%, then you will build equity in your home more quickly.
Also, prospective buyers may choose to put down a larger initial downpayment because their monthly mortgage payments will be lower.
While there are many benefits to having a larger downpayment amount, it may not be feasible or even the best way for you to buy your home. Many homebuyers may not have that much money on hand, or they may want to have a smaller down payment to have more available cash for home renovations, repairs, or emergencies.
A contract of purchase and sale is a legally binding document when signed by all parties. A buyer’s deposit can’t be released unless both parties agree in writing by signing a mutual release form. If the parties cannot agree to a release, the deposit is held in the third party trust account until an agreement, or court order is obtained.
If you make a conditional offer on a property, such as conditional to a home inspection or mortgage financing, the deposit is often due after all conditions have been removed. Of course, this needs to be agreed to in writing by both the buyer and the seller.
It’s important to keep in mind that there are additional costs to purchasing a home besides the deposit and down payment. Before you begin your home search, it’s a good idea to familiarize yourself with other closing costs of buying a home. When you’re ready, a mortgage broker and real estate agent can go over homebuyer closing costs with you!
*Disclaimer: The topics of discussion, content and resources on this website are general information that may not be the right solution or advice for you specifically. Not intended to solicit buyers or sellers currently under contract with a brokerage.
*Stock images from Social Squares