Buying a home or a property investment would be so simple if you did not need to come up with the deposit and wait forever for unconditional loan approval before signing a purchase contract!
In this article, we look at why a deposit is necessary and the rules that apply to its payment. Then we look at how to use Cooling Off Periods to tie up a property until the loan approval comes through.
Why is a 10% deposit required for a property purchase contract?
The Law is that a deposit is a guarantee (the law calls it an earnest) given by the purchaser when the contract is negotiated that they will perform the contract.
As Lord Justice Fry said in 1884 when deciding the case of Howe v Smith - The practice of giving something to signify the conclusion of the contract, sometimes a sum of money, sometimes a ring or other object, to be repaid or redelivered on the completion of the contract, appears to be one of great antiquity and very general prevalence.
The deposit paid under a purchase contract is applied against the purchase price when the contract is completed or is kept by the vendor if the purchaser defaults.
The courts refer to it as the customary 10% deposit in a property purchase contract.
Why is it not a 5% or 20% deposit?
The reason is that the courts consider 10% of the price to be a reasonable amount that a vendor can keep (the legal term is to forfeit) if the purchaser fails to complete the contract.
Therefore, a 10% deposit is a benchmark requirement for property contracts.
Is it possible to pay less than a 10% deposit?
The answer is yes, if the vendor agrees.
Vendors often agree to a 5% deposit payable on the signing of the contract, if the sale is by auction. They agree so as to attract potential purchasers who have sold their property but have not yet settled the sale or who cannot access the deposit paid under their sale contract.
If so, an additional clause is inserted into the contract which makes the 10% deposit payable by two instalments: 5% payable on the entry of the contract, and 5% payable on completion.
A 5% deposit is not so common for private treaty sales. When it is agreed, the deposit is often released to the vendor on the entry of the contract, as a quid pro quo for agreeing to a 5% deposit.
What ways are there to fund the deposit?
Deposits can be saved or sourced.
Funding the deposit for a first home or first property investment is the hardest because it must be saved. A useful guide to saving is to use the home loan repayments at 2% above the current interest rate on a loan amount sufficient for the property you are looking to buy, add rates and insurance, then deduct the rent you are paying. If (for example) the surplus is $300 per week, then the deposit will be saved at the rate of $15,600 per year.
Funding the deposit when trading up to a new home is easier because a deposit guarantee bond can be purchased and used as the 10% deposit. The current home is the security. The purchaser hands over the deposit guarantee bond to ‘pay’ the deposit. Not all vendors will agree to a deposit guarantee bond because although it is equivalent to cash, it is not cash.
Funding the deposit when buying an investment property is easy – borrow against the equity in an existing property. If the property is owner occupied, you need to avoid the tax trap of simply increasing the current loan. You need to take out an investment loan, separate from the current property loan, to ensure that the interest will be tax deductible. Increasing the current home loan will risk ‘muddying the waters’ because interest on the home loan is not tax deductible.
Are there creative ways to fund a deposit?
There are many creative ways to fund a deposit. Some are practical, others are difficult.
One way is to use a delayed settlement contract.
To illustrate, the deposit might be paid in instalments over a period of 3 months or longer, with the purchaser permitted to take possession paying rent (the legal term is possession under licence).
Another illustration of a delayed settlement contract is where a landlord agrees to sell the house to the tenant. The rent continues to be paid, but landlord agrees to accept the deposit instalments – if the instalments are $300 per week above the rent, then tenant will be paying $15,600 per year towards the deposit. This is called Rent to Own, which is a form of vendor finance. It works provided that the tenant is assessed to be creditworthy by a mortgage broker to take out a loan once the deposit has been paid, and the amounts payable are affordable within responsible credit guidelines.
Parents regularly fund deposits for their children to buy a home. If so, the parents need to decide whether to make it a gift or a loan. If it is a loan –
- it is usually interest free because adding interest creates a tax problem for the parents;
- it should be properly documented and secured by a registered Caveat over the property; and
- it is repayable on the sale of the property. Usually there are no regular loan repayments.
What happens to the deposit after it is paid?
Normally, the deposit is paid into the trust account of the vendor’s real estate agent or the vendor’s solicitor. It is held by them as ‘depositholder’ or ‘stakeholder’ until the contract is completed. On completion, along with the balance price, the purchaser hands over an ‘order on the agent’ which authorises the depositholder to release / pay the deposit to the vendor.
What is the legal status of the deposit pending completion of the contract? It is held by the depositholder for both vendor and purchaser until the contract is completed or terminated.
- If the purchaser does not complete the contract, then the vendor can terminate the contract and obtain a court order to pay it the deposit.
- If the vendor cannot convey the title because they are bankrupt, cannot remove a caveat or discharge a mortgage, or cannot remedy a defect in title, then the purchaser can terminate the contract and obtain a court order to pay it the deposit.
If the deposit paid is a significant amount, some vendor’s agents will invest the deposit and divide the interest equally between the vendor and purchaser.