What exactly is a lease-purchase option and how does it work? It’s a different breed of real estate transaction with pros and cons for both buyers and sellers.
How a lease-purchase option works. Lease-purchase or “rent to own” deals are more prevalent in a soft real estate market or so-called buyer’s’ market, meaning sellers outnumber buyers giving purchasers the upper hand in negotiations.
Because of the complexities of such a deal, sellers don’t have much motivation to accept a lease-purchase offer if it’s a hot market and buyers are plentiful.
With a lease purchase, the buyer and seller decide upon a sales price using a reasonable assessment of the home’s current value. That price is locked in during the option period, which typically lasts one to five years. The buyer pays an upfront non-refundable “option fee,” usually about 1 percent of the price of the home. Later, this option fee will go toward the down payment on the purchase of the house. The buyer then pays monthly rent plus a premium, the latter also going toward the down payment on the house.
At the end of the option period, the buyer decides if he or she wants to execute the purchase. If yes, then the option fee and premiums count toward the down payment. Once the buyer applies for a mortgage and is approved, one hurdle remains. The mortgage company must agree that the previously negotiated option fee and premiums jive with the fair market value of the home. Only then is the sale completed. The mortgage company could require a larger down payment. If the buyer decides not to purchase, the option fee and premiums are forfeited.
How lease purchase options help each party. For the seller, a lease purchase offers the chance for a guaranteed sale in a soft market under terms that make it easier for a buyer to complete the deal. For a buyer, a lease purchase presents the opportunity to buy a house with less than stellar credit or an insufficient down payment. The option period gives the buyer an opportunity to rectify those situations.
Risks for each party. For the buyer, lease-purchase arrangements pose multiple risks. First, if home values decline during the option period, a buyer could end up paying too much for the home. Second, if the seller fails to pay the mortgage during the option period, it could be foreclosed upon and the buyer evicted. The buyer should require proof of payments as part of the agreement. Third, most agreements specify that if the buyer is late on even one payment to the seller, the buyer loses credit for all rent premiums paid. Finally, the buyer is typically responsible for maintenance and repairs during the option period.
The risks to the seller are also significant. If the value of the home rises during the option period, the seller misses out on the chance to sell for more money. Second, if the buyer decides not to follow through and purchase the home, the seller must again try to sell the home and may face the burden of paying two mortgages at once. However, the option fee and monthly rent premiums should offset some of that risk.
Both parties should consult a real estate attorney with the drafting of the agreement since the terms are complex.