property investment

Discussion – Deposit bond

I just learned about something called Deposit bond while reading How to achieve Property Success by Margaret Lomas. It is quite helpful in helping people buying properties more efficiently.

Tl; dr;

Deposit bond is an insurance policy that purchaser gives to the vendor, instead of the deposit amount. This can be done because of various reasons. One of which is the purchaser may not have 10% deposit available after winning the auction, but still financially able to purchase the property.

To utilize deposit bond, one must seek approvals of the vendor. And have the auctioneer/vendor approves it on writing.

What is a deposit bond?

deposit button on keyboard
Source: smartline.com.au

A deposit bond is an insurance policy. It covers the vendor in the event that the buyer defaults on the purchase. The vendor will receive the full amount of the deposit, should the conditions of losing deposit are satisfied.

Instead of giving the vendor 10%, or any amount that represents a deposit, the buyer can just hand over the deposit bond. This means no money has actually been exchanged, and full amount of money will still need to be transferred at settlement date.

Benefits of a deposit bond

There are benefits to both buyers and sellers in the usage of deposit bonds.

For sellers, they enjoy the insurance that the deposit is fully paid, no matter the circumstances of the buyer. Since once the conditions are met, the insurance company will disburse the money. Then they will go after the other party to claim that amount back. It reduces the awkwardness when it comes to financials.

For buyers, the advantages may slightly be better.

  • They keep the deposit in their bank/offset accounts, and it continues to earn them interest/offset their mortgages during the settlement period.
  • In the situation where they are in the process of selling a property before purchasing another one. Buyers may not have the cash in their possession yet, and a deposit bond may be the answer to that circumstance.
  • The premium amount is small, on average it is 1-1.5% of the deposit.

An illustrated example of the deposit bond at work.

Jane purchased a property for $500,000, with a 6-month settlement term. She was required to put $50,000 as a deposit when she won the auction. However she did obtain the deposit bond for $500 and gave it to the vendor.

John also purchased a property for $500,000, with the same settlement term. However he pays the deposit up front.

Given that they both have other mortgages to pay, and assuming that their interest rates are the same at 4% pa. Over 6 months, Jane saved $1,000 ($50,000 * 4% / 2) in interest by parking that deposit amount in her offset account, while John has to pay that amount from his pocket.

JohnJane
Purchase price$500,000$500,000
Settlement term6 months6 months
Deposit$50,000$0
Deposit bond expense$0($500)
Interest over term period($1,000)$1,000
Total cost($1,000)$500
Illustration on John and Jane’s choice of handling deposits

Limitations of Deposit bonds.

Not surprising, nothing is all good. So what is the limitations of Deposit bonds?

First off, vendors have the right to not accept the deposit bond, and requesting the full amount of deposit to be paid up front. Especially in Victoria, where the deposit bond is not at all popular. This is why buyers need to obtain the approval in writing, should the disagreement arise later.

Previously, the deposit used to be transferred directly to the vendor’s bank account. They can use it to put down on another property if they need to, or pay the Real estate agents their commissions. The agents prefer to have the money sooner rather than later, so a deposit bond goes against their interest.

However, with the recent changes, everything has to be in escrow, meaning that a third party will hold all the money until settlement. In Australia, one such company is PEXA. Therefore it does not matter whether the deposit is in cash or in deposit bond anymore, since nobody can touch that money until settlement date.

Secondly, buyers will need to go through another round of financial approvals when they apply for the deposit bond. This can take more time before they can go out and find their next home.

Thirdly, it is hard to know the exact amount of the deposit in an auction situation, therefore normally the insurance company will insure the maximum amount of deposit on the maximum price that you can afford. As a result, sometimes it may not be beneficial to do so due to a higher premium. E.g. you’re insured for $50,000 deposit, but you only purchase a property for $300,000 (in this case, deposit amount is $30,000).

Summary

Deposit bonds are definitely something to look into, or be aware of when buying properties. I will certainly be exercising this options when purchasing my next property.

Should I be successful in utilizing deposit bonds, I will have a recap on the experience.

By Tuan Nguyen

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