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What is Lease to Own Contract?
Not every buyer can qualify for a loan when they want to buy a house. However, if you are tired of renting and paying your landlord’s mortgage, you still can do something about it with a “lease to own” type of a deal. It’s a hybrid between the traditional long-term lease and a purchase transaction, where you, now the “Tenant-Buyer” (instead of just a tenant) receive an exclusive option to buy the subject property for a pre-determined price during a pre-determined time frame. In most situations, the Tenant-Buyer ends up leasing the property that they can now call their home for one or two years, and they can exercise their option any time during the term of the option contract.
Lease to Own deals are perfect for somebody who is not ready to buy yet, because they don’t have their credit established yet, or they haven’t saved up for a sizable downpayment, or they want to minimize their exposure to a local real estate cycle. Consider a couple I recently dealt with who just went through a bankruptcy, had their scores in low 500s, but both had stable jobs paying decent income. Based on their credit, their purchase loan with 5% downpayment would be at around 8-9% annually, however, with the lease-to-own contract their payment would be comparable to a 4% mortgage. Not a bad deal, and it gave them a breathing room to re-establish their credit and then purchase this house with an FHA loan at 5.25% in only one year!
There are several specific issues that you have to understand before you jump into a Lease to Own contract.
Option price – This is the price of the house that is negotiated and contractually committed to now for both you and the current owner. Normally the price is set by considering the current value of the property, expected appreciation of the property during the term of the option, and a happy medium between the two that would satisfy both the current owner and the tenant-buyers. Let’s say that the house is currently worth $500,000 and the owner expects the house to appreciate at 10% a year for the next two years. The price negotiated between the parties on a one-year lease-to-own contract would probably be around $525,000 (1/2 of the expected 1st year appreciation), and $550,000 for a two year contract (1/2 of the expected 2 year appreciation).
Risk: If the property value actually declines during this time, you, the tenant-buyer, are at risk of loosing your option deposit. This is explained by the fact that due to this contract, you committed the current owner and prevented him from selling the property during the term of the option contract. If the owner receives the property back from you after a two-year option contract and you decided not to exercise the option, the owner is stuck with the property that lost its value and he lost the window of opportunity to sell the property before the value declined. That’s why the Lease to Own contracts are never found in declining real estate markets.
Option Deposit – because you effectively take the property off the market as a future buyer, you need to show your commitment to the transaction, therefore in Lease-to-Own deals there is no security deposit, instead there is an “Option Deposit”. Option Deposit represents your initial deposit on the future purchase. Normally it’s calculated off the future purchase price and can be set between 1.5 and 5% of the future purchase price, depending on the term of the option, creditworthiness of the tenants and other factors. More common are 2.5% deposits and they applied towards your purchase when you exercise your option.
Risk: Option deposits are normally non-refundable. If you decline to exercise your option or fail to do it in timely manner, you loose your entire option deposit. This deposit has nothing to do with how clean you left the place upon move-out, it has to do with the option contract and your failure to exercise the contract can cost you a lot of money. Sometime, if you need more time to purchase, you can negotiate an extension with the seller, but that would require the owner’s consent sweetened by an additional option deposit and possible increase in the option price.
Market Rent Credit – Since you are trying to transition into a home buyer vs. a tenant, you need to get used to making higher housing payments. Tenant-Buyers normally pay a higher rental payment under the terms of the Lease-to-Own contracts, however, there is a portion of the rental payment that might be applied towards your purchase. This portion is negotiated at the beginning of the lease. Normally, the higher your option deposit, the lower your rent and, hence, the lower your rent credit will be, and visa versa. Let’s say the market rent for the house is $3,000 per month, however, your lease payment is $3,500. This $500 difference will be applied towards your purchase when you exercise the option. In 12 months that’s $6,000 that you saved and effectively applied towards your down payment.
Risk: If you fail to exercise your option, just like with the option deposit, your rental credit will not be refundable to you, it’ll be money lost. Also, some leases put provisions that in order to receive this rent credit, you need to make timely payments. If you fail to make payments on time, even if you exercise the option, you still might end up loosing the credit.
Rental Application vs. Credit Application: A Question came up lately: Why do we have to fill out a mortgage loan application with our Lease-To-Own paperwork in addition to a typical rental application? Very simple: your goal to get into a Lease To Own contract should be to become a home buyer when you exercise the option. For the vast majority of Tenant-Buyers, the dream of home ownership is not realiizeable right now, however, they should start working on it as soon as possible. Don't wait until month 11 on a 12-months option to start figuring out if you can qualify for the loan or not. Start doing it from day ONE! A typical one-year option will give you plenty of time to correct errors on your credit, beef up your credit scores, and make yourself more appealing to the lenders. In addition, by going through a pre-qualification process now, you can see how much payments will be in the end and if you can even afford to exercise the option. Wouldn't you want to ensure that you will be in the position to afford the mortgage payments at the end of the lease, before you give a $10,000 non-refundable deposit to the landlord-seller? And finally, the tenants that go through the loan/credit application up front demonstrate to the investor how serious they are about their future. The landlord-seller wants to lease-option the house to a person who is serious about this opportunity, and if you are not willing to go through the credit application process, most investors will not even bother to write a contract with you.
Foreclosure vs. Eviction – Until you exercise the option to buy, you are still considered a tenant, not an owner, which means that if you fail to make your rental payments, you’ll be subject to late fees, three-day notices and potential eviction, not foreclosure. As a norm, eviction will invalidate your option contract and you will loose your option deposit and all accumulated rental credits. So, make sure that you can afford the payments on this contract before you jump into the deal.
Exercising the Option: Any time during and before the expiration of the term of the option contract you must complete the purchase transaction. Again, I emphasize the word “complete”! If your option contract expires on December 31, and you start your purchase process (i.e. obtaining financing for the purchase and actually getting on title as a new owner), chances are that your won’t be done with it by December 31, and subsequently you will be out of the option contract. Imagine that you are out of the contract, and the house appreciated by another 20% that neither you nor the owner hoped for initially, what is the incentive for the owner to give you an extension and leave tens of thousands of dollars on the table? So start preparing in advance, make sure to keep your cancelled checks during the entire term of the lease! Don’t make your payments in cash, do it in checks, money orders or something that you can copy and later give to your lender to prove timely payments. This is essential!.
Bonus point 1 - One exciting development in this area to keep in mind: more and more lenders allow you to treat the purchase at the time of the option exercise as a refi instead of a purchase. So if your house appreciated nicely during the term of the lease, you might have enough equity to put a new loan in place at 80% LTV based on the new value of the house instead of the purchase price of the house. This translates into lower interest rate and easier qualification process for the loan.
Bonus point 1 - If you lived in the house for two years, exercise the option on month 23 and sold the property during the month 25, you might still be able to qualify for a $250,000 home gain deduction ($$500,000 for a married couple) that’s normally available to homeowners. Consult your CPA for further details.
How do I get started:
(a) Contact us with a specific property in mind from our available inventory;
(b) Fill out a loan application form with our preferred lender, Provide supporting income and asset documentation. Start working with one of our mortgage consultants in order to get you ready for the mortgage at the time of exercising the option.
(c) Set up a meeting with one of our advisors to negotiate the contract or to find a suitable property for you.
(d) Bring the option deposit, first month rent and a security deposit;
(e) Order services for your new homes (gas, electric, water, sewer, trash, telephone, cable, etc.)
(f) Move, and enjoy the house.
For more information or to find a property that you would like to lease-to-own contact Alex Lisnevsky, Broker, West Coast Homes, (877) 233-5191.
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