In the years leading up to the financial crisis of 2007-08, the rent-to-own model — in which tenants/buyers have an option to purchase the house or condo they’re renting from their landlord/seller— was mostly offered by individual homeowners.
In the years following the crisis, it became a bigger option for tenants as large real estate investment firms bought up foreclosed homes across the country and implemented the rent-to-own model on a larger scale.
This helped formalize the rent-to-own model, whereby tenants can have a portion of their monthly rent payments accrue toward a down payment to eventually buy the home they’re renting.
With the rent-to-own option now available to more tenants to buy a house or condo, many consumers ask: how does rent-to-own work? To answer that question, let’s review the basics of rent-to-own.
If you’re looking for a place to live, plan to rent today but eventually want to purchase your own house or condo, and don’t plan on moving from the area you’re targeting for rentals, then rent-to-own could be an option for you. It’s also a good option if you have less than stellar credit and need time to build up good credit history while renting.
Rent-to-own is when a tenant signs a rental agreement or lease that has an option to buy the house or condo later — usually within three years. The renter’s monthly payments will include rent payments and additional payments that will go towards a down payment for purchasing the home. The lease contract will state the tenant’s rental payment, how much of the rental payments accrue toward a down payment, and how much the purchase price of the home will be.
Before you sign a rent-to-own lease from your landlord/seller, you should get pre-approved for a mortgage at the purchase price stated in the contract or lease to ensure you can afford the home. If you can’t, renting-to-own may not be the right option, because the contract could inflate the rental price slightly to account for the contribution of the rent payment that’s accruing toward your down payment (more on this below).
For example, let’s say you signed a rent-to-own lease that had your rental payments at $1,450, with $250 per month accruing toward a down payment, and a purchase price of $250,000. This would mean you’d accrue $9,000 over three years to go toward a down payment, which would be 3.6 percent of the purchase price.
Assuming you didn’t save any more money than that during that time, you could buy the home using a 3.5-percent FHA loan. As long as your pre-approval in the beginning of the process determined you could afford this, it might be a good deal.
What if you couldn’t afford this as a home buyer, but you still wanted to rent the home? You must ask the seller if the home could be rented for cheaper without the rent-to-own option. Usually this is the case, because most mortgage lenders only allow the down payment accrual to be a sum that’s above the local market rent. So in this example, not having a rent-to-own option might mean your rent is $1,200.
You should always have an attorney look at a rent-to-own contract or lease, because there is no industry standard template for writing rent-to-own contracts or rent-to-own leases. You need to be clear on who’s holding the down payment funds, as well as specific state regulations and tax considerations.
The obvious benefit of rent-to-own options is that your housing plans are in place all at once. This works if you don’t want or need to move. But if you do want or need to move, rent-to-own will limit you to that single property purchase option, and therefore might not be worth it.
Rent-to-own is also a good option for people who might have recent credit trouble that they need a few years to repair. Your credit score plays a big factor in the mortgage rate you’ll get, which can make a big difference in your monthly payments. Your credit score also helps determine whether you’re eligible for a mortgage.
Making your lease payments on time can help improve your credit. Just make sure your landlord/seller reports your rental payment data to the major credit reporting agencies. There are many other things you can do to improve your credit score while you’re in the rental period of your lease agreement. Start by requesting your free credit report. Federal law entitles you to one free credit report once a year from AnnualCreditReport.com, a website set up by the three major credit bureaus.
The rent-to-own purchase model can be a good option for sellers whose houses have been on the market for some time and they can’t find a buyer for a variety of reasons: Perhaps it’s more advantageous to rent in your area. Or maybe interested buyers don’t have high enough credit or enough of a down payment to qualify for a mortgage. The rent-to-own option can attract potential buyers by giving them a chance to slowly build credit and pay their down payments over time. Just make sure your potential buyers can have high enough credit to qualify for a loan when it’s time to buy.
If you’re a landlord looking to sell your home and want to give a renter the rent-to-own model, you’ll need to consult an attorney to draft a contract or lease for you since (as noted above) there are no standard templates for this kind of lease option for sellers.
The two most common benefits to a home owner for selling their house or condo in a rent-to-own agreement are:
- You can lock in the future sale price of your home now, and not have to worry about market fluctuations.
- If you’re renting to a tenant who eventually wants to own the home, the quality of the tenant is likely to be much higher, and they will treat the house or condo with more respect.
One drawback of the rent-to-own selling option is that you might want to sell your house or condo sooner, and if your contract or lease doesn’t allow for you to do so, you could be locked into the terms you agree to with your tenant/buyer. Consult your attorney on how to make this sale provision of your contract negotiable if you need this flexibility.
Institutional vs. Individual Landlords/Sellers
Individual homeowners offering a rent-to-own option for their leases usually set up contracts for three years. Institutional homeowners (like real estate investment companies) often have two-year lease contracts that can be extended for up to four more years after the initial lease term. This offers more flexibility for tenants/buyers.
Institutional rent-to-own companies are often publicly traded, so they’re subject to a whole host of regulatory scrutiny, which means they’ll be more stringent about consumer protection. This means your contracts will be very clear about the rules of engagement, who holds the down payment funds, and how disputes are resolved.
Big rent-to-own companies also have consumer help resources to help you with credit counseling and repair. In fact, some companies required their renters to go through credit counseling. If you need credit help, this might be a great resource for you.
If your credit is perfect, you’ll want to avoid a company with this option, or maybe stick to working with an individual landlord/seller.
Are you tired of renting, basically “throwing away” your hard-earned money each month on rent, wishing that money could go towards a mortgage? You want to own a home, but do not have much extra money for a down payment or have a hard time qualifying for a traditional mortgage loan. No doubt you have heard of an alternative purchase option known as rent-to-own.
Are the rent-to-own options really as great as they seem? This solution to home buying can have potential risks and be a bit more complicated than the traditional route of financing and purchasing a property. There is a dirty little secret about the rent-to-own process that you need to know about.
Rent-To-Own Contract Options
There are a couple of options to consider before going into a rent-to-own agreement. With a lease-option agreement, the tenant has the option to buy the home at the end of the standard rental agreement. This is typically the more preferred rent-to-own deal.
A lease-purchase agreement is another type of agreement that legally obligates the tenant to purchase the property at the end of the lease terms agreed upon. This binding rent-to-own contract is much riskier and the potential buyer needs to be certain he or she will purchase the property, or the loss can be costly.
The buyer and seller negotiate the purchase price with the signing of the lease agreement and in some cases, at the end of the lease period. In most cases, the rental term for a rent-to-own lease is one to three years. The buyer must present funds to pay the seller an upfront payment or option fee, also known as option money or option of consideration. This is usually 1 to 7 percent of the agreed-upon purchase price.
In addition to the monthly rent payment, the buyer pays a Rent Premium or Rent Credit. This extra amount credited toward the purchase price of the home makes the monthly payment higher than what the normal rental rate would be. It is important to know what you are paying and to be sure the extra you are paying will be credited to the purchase price.
Potentially How the Rent-to-Own Model Works
Let’s see how a typical rent-to-own agreement would work out. For example, let’s say that the rental rate for a 3 bedroom, 2 bath house is $1,500. Now the additional amount that you will pay towards the purchase price is negotiable. Generally, you should expect to pay 20% to 50% above the market rent. For the sake of argument, let’s go with 25%, which is about average. So you will pay $1,500 a month in rent and an additional $375 towards the purchase price. If your lease period lasts 3 years, you would have a $13,500 credit. If the purchase price is $280,000 and if you paid a 3% option fee of $8,400 and combined that with the credit, you would end up with a down payment of $21,900 or 7.8%.
Rent-to-own allows prospective buyers to lease a property with an option to buy. Both buyers and sellers can benefit from these arrangements, but it’s essential that everyone understands the risks.
Learn how rent-to-own works, the pros and cons of rent-to-own agreements, and the factors that buyers and sellers should take into account.
Definitions and Examples of Rent-to-Own
Rent-to-own contracts are alternatives to traditional home loans. At the outset, such arrangements are much like traditional leases landlords and tenants might sign. However, the contract also gives the renter exclusive rights to purchase the home at a specified point in the future. A portion of the money paid upfront and a part of the established monthly rent also go toward the purchase price.
Any two parties can enter into such an arrangement, but they sometimes are used as part of housing programs designed to establish affordable housing or revitalize neighborhoods.
How Does Rent-to-Own Work?
The buyer and seller establish a purchase price for the home in their contract. At some point in the future, the buyer can purchase the home for that price—regardless of what the home is actually worth.
When setting the price, a price that’s higher than the current price is not uncommon, to account for projected increases in home values. If the home has gone up in value faster than expected, things work out in the buyer’s favor. If the home loses value, the renter can back out of the deal. Buyers usually apply for a mortgage when the time comes to purchase the home.
There are two types of rent-to-own agreements. Lease-option agreements give the option to buy the home at the end of the lease. Lease-purchase agreements establish the obligation to do so.
Buyers typically pay an option premium upfront, often up to 5% of the ultimate purchase price. The payment is nonrefundable, but it can be applied to the down payment.
Contracts also establish the amount of monthly rent, but the renter typically pays a little bit extra each month. The additional amount is usually credited to the final purchase price, so it reduces the amount of money the buyer has to come up with when buying the home. The extra rent is nonrefundable. It compensates the seller for agreeing not to sell the property to anyone else until the agreement with the renter ends. Contracts should also stipulate who is responsible for maintenance during the rental period.
Is Rent-to-Own Worth It?
Rent-to-own agreements make sense for some buyers, but not for others. If you have shaky credit or need time to save a down payment, rent-to-own may be the right choice for you. A lot depends on your finances and the state of the housing market.
A price-to-rent ratio measures the relative affordability of purchasing vs. renting in a housing market. It is calculated by dividing the median price of homes sold during a specific time period in a particular market by 12 months’ worth of the median monthly rent in that same market.
For example, the median price of homes sold in the U.S. during the fourth quarter of 2021 was $408,100, while the median monthly rent paid during that same time nationwide in the 50 largest metros was $1,771. So, to get the price-to-rent ratio, you would divide 408,100 by 21,252 (1,771 multiplied by 12) and come up with 19.2. The higher the ratio, the more favorable the market is for renting. The lower the ratio, the more favorable the market is for buying.
Of course, average home prices and rents vary from market to market, so the national average provides little more than a broad overview. To be accurate, you need to base your calculation on current figures where you are planning to buy or rent.
Home ownership is one of the badges of the American Dream. Owning your own home affords you a financial reservoir for future needs and investment. It gives you a sense of accomplishment. It provides you with a place to settle into and build a life around. Home ownership appeals to many people, but it is also very difficult for many people to reach. If you don’t presently have good enough credit to qualify for a mortgage, you might consider entering into a rent-to-own contract.
How It Works
Renting to own is exactly what it sounds like. After finding a house or other property listed as a rent-to-own, you will enter into a dual arrangement by which you are both a tenant and a buyer. As a tenant, you will pay the owner a fair market rent for the duration of your tenancy. As a buyer, you will pay the owner an up-front sum as well as a premium on your monthly rent. Eventually, you will have paid the owner enough extra money to purchase the house outright.
Alternatively, the rent-to-own contract may only last until you have paid a suitable down payment on the house, at which point you will have the option of buying the house outright or walking away. In most instances, you can also make an outright purchase before the contract expires. A rent-to-own contract spells out both the conventional details of a rental lease agreement and the terms by which the tenant can purchase the house or walk away from the arrangement.
Alternative to a Mortgage
Rent-to-own agreements don’t require a mortgage, which makes them an appealing avenue to home ownership for people who wouldn’t qualify for one. They also don’t require as large of an up-front payment, with the payment being a modest 1 to 7 percent of the purchase price. Meanwhile, you may begin building equity as soon as you enter into the agreement.
Try It Before You Buy It
Rent-to-own agreements give you the option of living in a house for an extended period of time before committing to buying it. This gives you the chance to learn the quirks, faults and charms of the house, as well as the property and the neighborhood. This makes a very nice perk if you are already interested in renting to own.
While a rent-to-own contract will almost always cost you more in the long run than a traditional mortgage, you will save a lot of money up front during the tenancy phase of the agreement. This is because the owner continues to be responsible for taxes, insurance and some of the maintenance, depending on the agreement in the contract, until you complete the purchase. You will also save money up front with the lower down payment.
Disadvantages and Risks
If you decide not to purchase the house once your contract expires, you will forfeit your down payment (and usually your rent premiums) and find yourself back at square one in the game of home ownership.
You must also beware of unscrupulous sellers and lease-purchase companies who will buy a home for you and then lease it to you on a rent-to-own contract. Seek legal counsel or professional assistance before committing to any rent-to-own contract. Watch out for any contract that deviates from the simple premise of renting to own by charging you extra fees.
Good examples of rent to own contracts should include such factors as due dates, escrow, and whether monthly rent would go to the purchase price of the home. A rent to own agreement outlines an arrangement between various parties in the leasing of a property, and it allows tenants to purchase the property when the leasing term ends. A rent to own contract must be drafted according to state landlord-tenant lease laws and follow a state’s real estate commission laws.
Rent to own contracts are also known as:
- Lease Option Agreements
- Lease to Own Agreements
- Lease with Option to Purchase Agreements
- Lease Purchase Contracts
- Option to Purchase Agreements
- Contract to Deed Agreements
Rent to Own Benefits
A rent to own agreement is applicable when tenants want to rent properties for a certain period, usually multiple years, while having the option to buy a property at or before the end of the lease. Rent to own contracts are beneficial to tenants for a variety of reasons. For instance, tenants may not have a down payment or insufficient income to obtain a loan. In addition, their credit scores may not be high enough, or they may not be ready to commit to homeownership.
If you wish to buy a home, but your credit score is not high enough, renting a property with the option to buy it later starts you on a path to homeownership. In addition, it is a great option for renters who wish to buy a particular home, but cannot do so right away.
In a slower market, lease option agreements give sellers additional options while securing steady income source. If you have a hard time selling a property in a slow market, a rent to own contract can you enhance your cashflow until you sell the property.
Rent to Own Traits
Sellers and buyers can benefit with the assistance an attorney who specializes in real estate. A rent to own contract lists the same attributes seen in a normal lease agreement, such as:
- Due date and monthly payment
- Late fees and grace periods
- Description of property
- Homeowner and tenant info
- Lease term
Rent to own agreements include details, including:
- Option fees
- Portion of rent going to the purchase price
- Penalties if the agreement is violated
- The way the property price will be assessed
Review all documents carefully, and you should make sure you fully understand the terms and conditions of the agreement before signing. You must assess a rent to own agreement carefully, but it is an agreement that benefits both parties and worth entering into.
Sellers tend to offer a rent to own option if they do not intend to sell the property, or in the following cases:
- A rent to own agreement comes with a higher sales price if the market declines
- A contract lists tenants who properly care for the property
- A contract possesses a longer rental term that has steady income
- The seller has a positive cashflow on the property
- The agreement comes with minimal risk and an option fee that’s not refundable
Further, a seller may place additional rents into a safeguarded escrow account that will go to the down payment. Certain sellers may place additional funds that’s paid off to the purchase price of the property. A rent to own agreement also has no commission that needs to be paid to brokers. If the property has a hard time being sold, a rent to own agreement could be a sound way to sell the property later. In addition, rent received with the option fee tends to be above market average.
Benefits and Drawbacks
A rent to own agreement allows tenants to get an exclusive option that other buyers may not receive. A drawback for sellers is that they must sell the property for less than the current market value if the agreement mandates a set buying price.
On the other hand, rent to own can work in a seller’s favor. For owners with no tenants and no rent to own agreement, potential buyers could lose interest, especially if the market shifts in an unfavorable light. Therefore, the seller would be left with a property that’s difficult to sell and has no cashflow if the property is unoccupied.
If you need to find examples of rent to own contracts, submit your legal inquiry to our UpCounsel marketplace. UpCounsel has a variety of experienced lawyers that will help you draft a rent to own agreement if you wish to create a rent to own program for your property. In addition, our lawyers will help renters understand contract terms and invoke their rights as tenants.
Last week we discussed land contracts as a tool for buying or selling a home in a difficult market. Today, we’ll take a look at rent-to-own agreements, which are similar, but with some important differences.
Both land contracts and rent-to-own (also called lease-to-own) agreements are a type of seller financing. They can make it easier to buy or sell a home during times when mortgage financing is hard to come by, by eliminating the need to get approval from a regular lender.
Rent payments go toward equity
In both a rent-to-own or land contract, the buyer makes regular monthly payments to the seller rather than to a bank or other financial institution. After a period of time specified in the lease/sales contract – often two to five years – the buyer pays off the balance of the sales price by taking out a regular mortgage on the property.
In a lease arrangement, the deal is structured so that the buyer has the option of buying the property at a predetermined price at the end of the contract period. On a land contract, the buyer purchases the property at the outset, with a balloon payment due to the seller at the end of the contract. In both cases, some or all of the buyer’s monthly payments, plus any money paid up front, are figured into the purchase price to help the buyer establish equity in the property.
The seller as landlord
The big difference between a rent-to-own arrangement and a land contract is that the seller maintains control of and responsibility for the property in a lease deal. The seller is responsible for the maintenance of the property, any repairs and for paying property taxes and insurance, the same as any landlord. The seller also gets to deduct those costs, as well as any mortgage interest, on his or her tax returns.
On a land contract, the buyer is responsible for property taxes, insurance and mortgage interest, although these will usually be paid through the seller. However, the buyer does get to deduct them from his or her taxes; the seller cannot.
A buyer’s right to make improvements or alterations to a property may also be more limited under a lease agreement, unless those rights are specifically granted through the lease contract.
For a seller, one of the main advantages of a lease-to-own arrangement is that it’s easier to evict a buyer for nonpayment. The process for evicting a tenant for nonpayment is generally faster and simpler than foreclosure, which is typically required in the case of a land contract.
An option, not obligation, to buy
For a buyer, a rent-to-own agreement carries less of an obligation at the end of the contract than a land contract does. In a lease-to-own, the buyer has the option – not the obligation – to buy the property at the end of the contract period. With a land contract, the buyer has already entered into a loan agreement for the full purchase price. If the buyer decides not to – or is unable to – obtain a regular mortgage to cover the balance remaining at the end of the contract, that’s a default and can do serious harm to the buyer’s credit.
For the buyer, this makes a rent-to-own deal a type of “try before you buy” arrangement. If problems with the home are subsequently discovered, or if property values fall significantly, the buyer can back out of the deal with no further consequences, although they will be out any money they have paid in rent.
To guard against this, sellers typically charge an upfront fee called an “option to buy.” Usually several thousand dollars, it gives the buyer an added incentive to follow through on the deal and a cushion for the seller in case the buyer backs out due to declining home values.
For buyers, one of the upsides of a land contract is that you can obtain title insurance and register the sale with the county (though many are not). This allows you to identify any restrictions or liens on the property up front, which you may not be aware of if you opt for a rent-to-own arrangement. Registering the sale also provides some degree of protection against subsequent liens against the property.
In a lease, the buyer loses any money paid in rent and upfront if they cannot keep up with the rent payments or are unable to obtain regular mortgage financing to complete the transaction at the end of the contract period. In a land contract, buyers may still retain an equity interest in the property in these situations, depending on state law.
Finally, the main shortcomings of land contracts are also true of rent-to-own agreements. Specifically, if a buyer is unable to qualify for a regular mortgage now, there’s a good likelihood they may still be unable to when they contract period expires, even though many assume their finances, credit or equity position will have improved by then. Also, it’s typically a more expensive way to buy a home than through a regular mortgage.
If you decide to go the rent-to-own or land contract route, it’s important for both buyers and sellers to get the help of their own attorney to advise them and help write the lease/sales contract. The advice of a Realtor with experience in setting up such agreements is strongly recommended as well.
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New Yorkers should use caution before entering into any rent-to-own or any other form of alternative home purchase finance agreement. DFS is investigating whether alternative home purchase agreements, such as rent-to-own, lease-to-own or land installment contracts, being offered in New York constitute unlicensed, predatory mortgage lending. These alternative home purchase agreements often are being marketed to financially distressed consumers, promising a path to homeownership, but putting consumers at risk.
DFS is concerned that companies may be targeting vulnerable consumers, playing on their desire to achieve homeownership to get them to sign onerous and illegal home finance agreements that often do not lead to homeownership.
The DFS investigation has raised a number of concerns that any New Yorker who has signed, or is considering signing, a rent-to-own or other similar agreement should know. New York residents should know that lease-to-own, rent-to-own and land installment contracts may violate New York laws and regulations regarding fair lending, mortgage protections, interest rates, habitability, property condition and/or real property disclosures.
Consider Your Options
Residential leases and mortgage agreements are required to provide basic consumer protections. Some companies, however, claim to offer a hybrid agreement – part mortgage, part lease – that does not need to provide any of the standard consumer protections. Although a lease-to-own or other alternative home purchase agreement may appear to offer a path to homeownership, these agreements may impose harsh terms with little or no safeguards. Before entering into one of these agreements, you should carefully consider whether a traditional lease is a better option.
Know Before You Sign
Companies engaged in the rent-to-own or lease-to-own business tend to deal in severely distressed properties – homes that have been vacant for a long time and often require a substantial amount of work. Rent-to-own agreements impose all of the obligation to repair the properties, and the substantial cost of the repair work, on the consumer, whereas New York law would put such obligations on the landlord. And, if the arrangement is similar to homeownership, then the homeowner has protection under New York foreclosure law.
In addition, be careful of arrangements that create a false sense of transparency. For instance, a company may provide consumers with lockbox codes allowing them to freely tour a property to assess what work it may need. While a tour might suggest an opportunity to identify issues with a property, consumers typically conduct these inspections at a disadvantage. For example, property tours are typically conducted when the utility services are not turned on, depriving consumers of the opportunity to test whether the property has basic services.
Consumers are further advised to learn what a company offering a lease-to-own or other alternative agreement knows about a property. Although companies may tell you that they do not have any information about a particular property, some companies hire contractors to conduct inspections of properties after they have been acquired. These reports identify issues such as black mold, termites, asbestos and other health and safety hazards before a consumer has even had a chance to tour the property. So, while offering open property tours may look like a company is being fully transparent, the tours are actually just your opportunity to learn what a company probably already knows. And if you do not identify an issue, the company will not inform you.
Protect Your Rights – You May Be Entitled to Free Legal Counsel
If you currently live in a rent-to-own home or other similar housing, you may have certain legal rights, including in the event of any payment default. In New York, under the common-law doctrine of “equitable mortgage,” residents in single-family homes making lease payments while improving the condition of the home, over time, accumulate equity in the home. One consequence of that equity is that the company cannot just evict you if you fall behind on making payments. Rather, you should be entitled to the protections of a foreclosure proceeding, and if you have received an eviction notice, you should speak with a lawyer about an equitable mortgage defense.
Please see below for contact information for organizations that may offer free legal representation.
Housing counselors that handle foreclosure-related issues can give you advice on your options and resources at little or no cost. They may also be able to negotiate with your lender for free and help you find free legal services in your area.
Housing counseling resources for New Yorkers include:
- New York’s Homeowner Protection Program (HOPP), which connects with housing counselors and legal services at no cost. Call the HOPP hotline at (855) 466-3456 or visit homeownerhelpny.com.
- You can find a list of approved non-profit housing counselors by county here, on the DFS website.
- 24-Hour assistance is available toll-free on the HOPE NOW hotline at 888-995-HOPE (888-995-4673). HOPE NOW is an alliance of HUD approved counseling agents, servicers, and investors that provide free assistance.
- If you live in New York City, you can also call 311.
If you are in a foreclosure court case, you should consult an attorney.
Contact a lawyer and review your mortgage documents. Make sure your loan is not in violation of any laws. If you do not have an attorney, the New York State Bar Association may be able to refer you to an appropriate attorney for your situation.
If you cannot afford a private attorney, resources for free or low-cost legal assistance include:
Lease Option or Lease Purchase Agreements, commonly referred to as “Lease-to-Own” Agreements are mistakenly used interchangeably, although they are vastly different. These agreements allow a potential buyer to occupy the seller’s property for a period of time before completing the sale. This arrangement can assist either or both parties in meeting their goals and needs with respect to the transaction and their specific circumstances. In some instances, these agreements may even allow a buyer the opportunity to build a bit of equity in the home as well.
It is important to understand the distinction between a Lease Option Agreement (“Lease Option”) and a Lease Purchase Agreement (“Lease Purchase”).
A Lease Purchase consists of two separate contracts:
- The residential lease which provides for the tenant-buyer’s lease of the property for a specified term; and
- The contract for sale which obligates each party to the typical terms of a residential purchase agreement upon the expiration of the specified lease term.
Typically this kind of agreement provides what are referred to as cross-default provisions to ensure that a breach of one of the agreements will result in an automatic breach of the other. As the tenant-buyer has contracted to purchase the property in the context of a Lease Purchase, oftentimes the lease will provide that the tenant-buyer is responsible for maintenance and repairs which are typically the duty of the landlord.
A Lease Option operates very similarly to a Lease Purchase in that it consists of two agreements and theoretically allows for the tenant to ultimately purchase the property. However, the tenant does not sign a contract for sale but instead enters into an option agreement (“Option Agreement”).
An Option Agreement provides the tenant-option holder the right to purchase the property at an agreed price during the lease term or other specified term, also called the “Option Period”, in exchange for a fee paid to the seller called the “Option Fee.”
This looks very similar to a deposit on a contract for sale which is why the Lease Option and Lease Purchase are so often confused. A Lease Option also provides for the cross-default provisions, and the Option Fee referenced above is typically non-refundable. Upon a tenant-option holder’s election to exercise their option to purchase the property, the Option Fee is usually credited to the purchase price, however, there may be an additional deposit required upon the parties’ execution of the contract for sale.
A key distinguishing factor of the Lease Option is that the agreement does not obligate the tenant to purchase the property, but does obligate the seller to sell the property if and when the tenant properly exercises the option to purchase.
Both the Lease Purchase and Lease Option create landlord-tenant relationships. Therefore, if the tenant defaults, the landlord-seller would evict the tenant-buyer or tenant-option holder like a normal tenant. An issue that may arise in the context of an eviction of a tenant to a Lease Purchase or Lease Option is an equitable interest claim. Although not typically successful, a tenant may assert an ownership interest in the subject property, which is grounded in the idea that a Lease Purchase or Lease Option is essentially the equivalent of a sale, similar to an installment land contract (or contract for deed), whereby the seller retains title to the property as security until the balance is paid by the buyer. If an equitable interest argument prevails, the landlord-seller will be required to remove the tenant by way of foreclosure action, as opposed to a more simple eviction.
What to consider before an agreement
To avoid a potential successful equitable interest claim, a seller should consider certain things when constructing the Lease Purchase or Lease Option:
- Structure of Lease Purchase or Lease Option should not resemble a contract for deed;
- Limit the lease term to one year or less;
- Provide for a security deposit (sellers don’t take security deposits, landlords do);
- Seller should continue to pay taxes and insurance on the property;
- Do not give large rent credits (this only creates more equity the tenant can claim);
- Refrain from using the words “credit”, “seller” and “buyer” in the lease agreement and/or option agreement portion of the Lease Option; and
- Will the tenant-buyer/option holder be making improvements, and what will the value be of such improvements?; and
- What is the difference between the tenant-buyer/option holder’s option price and the fair market value of the property? The closer these amounts, the more equity one could claim.
If you have questions regarding Lease Purchase, Lease Option or any real estate transaction, please contact us.
During the option period, which is typically less than three years, the prospective buyer lives in the house and pays rent, a portion of which goes toward the down payment. For example, if the home’s rent is $1,000 per month, the owner might charge $1,200 per month and credit the renter with $200 per month toward the down payment, an amount known as the rent premium. Added to an upfront “option fee” of, perhaps, $5,000, the renter will have contributed a total of $7,400 to their down payment by the end of the first year. If the renter decides not to purchase the house, they will lose the rent, the rent premium and the option fee to the seller, who will then search for a new tenant.
From the Seller’s Perspective
From the Buyer’s Perspective
Strategies for Renters
Renters should obtain renters insurance, as they are not yet homeowners and ineligible for homeowners insurance, and their personal possessions are likely not covered by the owner's policy on the property.
Also, consider that most renters are often less savvy than landlords, who better understand how difficult it can be to obtain a home loan. Rental owners might enter into a rent-to-own agreement knowing that their renter will never be able to obtain a sufficient loan to buy the house. Such unscrupulous individuals can use a rent-to-own option merely as a strategy to get higher-than-market rates for their properties.
Sellers also need to watch market conditions to predict whether their house’s value is likely to appreciate so that they don’t lock themselves into selling it to their tenant for less than its market value.
- Renters who truly believe they will eventually purchase the house should try to extend their option period so that they have more time to build up savings, repair credit, and prepare for a large purchase. On the other hand, renters who eventually opt out of the lease-option agreement will feel the sting even worse if their option period was especially long. Sellers usually negotiate for a shorter option period so that they receive the funds for the house sooner.