What Is a Lease-Option Purchase?
A lease-option purchase (aka "rent-to-own purchase" or "lease purchase") is a lease combined with an option to purchase a property within a specified period of time, usually 18 to 36 months, at an agreed-upon price. This basically means you are leasing or renting a property with an option to buy it at a future date. The future price of the property should be fixed at the time the lease-option is signed.
Usually there is an up-front payment of some amount to purchase the option. The amount can vary. Sometimes the monthly rent payment is larger than normal and the excess is used to purchase the option. In some cases, the option money can be applied toward the down payment for the later purchase of the home.
Lease-purchase plans can be structured in such a way that both parties benefit. They can also be structured so that all the benefits flow to one of the parties and none to the other. Buyers especially need to be careful because they usually know less about the market than sellers, and the seller usually provides the contract.
Such arrangements have gotten popular in the post-crisis market because many potential home buyers can no longer meet the tougher loan qualification requirements of today, and many potential sellers are unable to realize a satisfactory price in a down market.
Typical Features of a Lease-Option Purchase
In a typical arrangement, the buyer pays an option fee, usually 1% to 5% of the sale price, which is credited towards the purchase price when the option is exercised. The buyer pays market rent, and an additional rent premium that is also credited to the purchase price. The option fee, option period, rent, rent premium, and purchase price are all negotiable items. If the purchase option is not exercised, the buyer loses both the option fee and the rent premium.
Buyers generally prefer a long option period because it provides more time to accumulate savings and repair credit. A long period however, can be costly if they are never able to exercise the option, since they lose the rent premium they have been paying, in addition to the option fee. Sellers generally prefer a short option period, but if it is too short, the house won't be sold.
The option fee and rent premium are viewed differently by buyers and sellers. To the buyer, they are part of the equity in the house they fully expect to own. To sellers, however, these payments are the best guarantee that the buyer will buy the house; if they don't sell, the payments are retained as income.
A lease-option purchase contract may or may not give the renter/buyer the right to sell the option. And generally, the title remains in the sellers' name until after closing. Ultimately, the seller is still responsible for making any and all mortgage, tax and insurance (not renters insurance) payments. With this the seller retains the right to continue to enjoy the tax deduction on his/her mortgage interest payments during the option period.
Using a Lease-Option Purchase to Buy
The lease-option offers homeownership opportunities to consumers who can't qualify for a loan from any source, but who are prepared to bet on themselves. The bet is that before the option period expires, they will qualify for the mortgage they need to exercise the purchase option. During the option period, they have the opportunity to rebuild their credit and accumulate savings while living in the house.
Even though it can be costly, the right not to exercise the option is of great value to the buyer. If there is something seriously wrong with the house, neighborhood, or neighbors; or some unexpected life event such as a divorce occurs, the buyer can cut hi/her losses by not exercising the option.
Risk to Buyers
A major threat to buyers is contractual provisions that can nullify their option, such as the failure to pay the rent on the first day of the month. Such provisions are most likely to appear in contracts used by developers or investors that own multiple homes. Another common risk the buyer face is failure to qualify for a home loan. Individuals who attempt to buy homes on a lease-option rarely end up buying the home. This often has to do with the reason they try to buy on a lease-option in the first place. They usually cannot qualify for a home loan and expect that they will be able to qualify after a period of time. Later, they find they still cannot qualify - whether it is because of poor credit, lack of income (documentable income), or lack of savings to have a large enough down payment.
Using a Lease-Option Purchase to Sell
Most home sellers want a cash sale, but for those prepared to hang on to the property awhile longer, the benefits can be compelling. Buyers unable to become homeowners in any other way are generally willing to commit to a future price substantially higher than the price at which the property could be sold for today.
The Option Fee and Rent Premium Are Not Part of the Down Payment
The option fee and rent premium are not part of the down payment unless the seller agrees to relinquish the right to retain these payments in the event the buyer doesn't exercise the option. Few sellers would be willing to do that. But the option fee and rent payments do make the required down payment slightly smaller.
For example, the parties agree to a sale price of $100,000 and the option fee and rent premium add up to $5,000 when the option is exercised. From the standpoint of the lender, the price is $95,000 and a 5% down payment requirement would call for a down payment of $4750 instead of $5,000.
With any of the strategies listed here, it is always wise to consult a real estate attorney to find out your legal options of any part of the deal.
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