Lease Option To Buy

Although they've actually been around for decades, rent-to-own contracts that substitute for mortgages and conventional home loans are enjoying a surge in popularity in several regions of the country. The slumping real estate markets in parts of the U.S. fuels these deals, where homes can sit on the selling block for months at a time.
Leasing with the option to buy is probably the form of financing that's least understood by salespeople and prospective buyers. But it may be the solution for buyers who need time to save for a down payment or closing costs, to cure credit deficiencies, or to resolve problems precluding a short-term closing.
Add to this the recent tightening of rules and regulations for bad credit loans and a near perfect storm has been created for rent-to-own scenarios. It sounds like a great way for home sellers to speed up the sale of their home.
Leasing with the option to buy is a hybrid between an outright contract to purchase - with established sales price, financing terms, and date of closing - and a lease, which provides for a limited term of use of a property in exchange for rent. A lease-with-option-to-buy agreement between a buyer and a seller lists the purchase price, the amount of option funds, the length of option period, the rental amount, and the rental credit.

As with any other sales contract, the terms and conditions between the seller and the buyer are negotiable. However, since the buyer's financial parameters will administer much of the transaction's structure, the buyer must give the seller an incentive to negotiate. That's usually done with the purchase price. Many buyers come close to meeting the listing price. One of the most common rent-to-own contracts is the land contract.
A land contract is essentially an agreement between the buyer and seller where the seller "finances" the buyer to purchase the home. A payment schedule (monthly amount multiplied by the number of months) is agreed upon, and the buyer pays a down payment as a security deposit to the seller. The title of the home remains with the seller until the buyer has made all the payments. The payment schedule usually covers only a part of the sale price of the home, which means that at the end of the payment schedule, an outstanding balance remains. This is usually paid using what's called a balloon payment. So, the buyer pays payments for a set period of time, and then must pay the remaining amount to buy the home. For example, the buyer may pay $950 a month for 10 years and have a balloon payment of $40,000 due at the end of the 10-year contract.

Leasing with the option to buy has several benefits for the seller. First, it attracts prospective buyers from out of town who want immediate occupancy and those who would otherwise delay their home purchase. Such efficiency minimizes potential carrying costs for sellers on their former residence.

Another benefit, leasing with the option to buy enables the seller to cover the monthly mortgage payment on the house. Since option funds are typically delivered to the seller when the lease is executed but are not taxable until the sale is closed or the option term expires, the seller may use them to buy in a new location.

One more plus is that the seller is offering favorable terms to the buyer, a higher sales price can often be negotiated than if the buyer were paying cash and closing quickly. Buyers seem to understand the concept of trading price for time and rent credit, which can make it easier for the seller to get the best possible price.

Finally, the seller should have more confidence in the quality of the tenant because, by virtue of the option funds and the higher-than-market-value rent payment, the tenant has shown a serious intent to buy. Because they anticipate owning it, such tenants may take better care of the property than would other tenants.

The lease option benefits the buyer as well. If the purchase price is negotiated at the home's current market value, the buyer will begin building equity before closing as the home's value appreciates.
In addition, the buyer takes immediate possession of the property while accumulating funds for a down payment and closing costs - sort of a forced savings plan.

For the buyer, the prospect of losing the deposit option funds isn't a pleasant one. But since this possibility is stated at the beginning, it won't come as a surprise. Depending on how the option agreement is structured, the buyer may want to be able to assign the option agreement to another buyer. In doing so, the buyer could recover the option funds from the new buyer. As long as closing occurs, the seller is usually satisfied. Another alternative would be that the seller and the buyer agree to extend the option period by negotiating additional option funds or increasing the purchase price.

Here is the risk: Land contracts are not always publicly documented and recorded; rarely a good idea when dealing with real estate and this much cash at risk. Another common rent-to-own scenario is renting or leasing with the option to buy. Such options are different from land contracts in that the agreement is usually filed and is a legal arrangement. They give the renter or lessee the option to buy the property at a set time during the loan. With an option, rent payments become equity in the property.
While the benefits of rent-to-own arrangements may seem strong, both the buyer and seller need to be aware of problems that can result from poor planning. A few of the most common problems faced with rent-to-own scenarios are:

  • Repossession can be difficult if the buyer defaults on payments.
  • The seller is stuck with any repairs, even if the buyer caused them.
  • The seller may be responsible for real estate tax and property insurance.
  • If anything goes wrong, the buyer may lose any money paid, including the deposit
  • When the time comes, the buyer may not be able to finance the balloon payment after all (remember, the buyer could not get financing to buy the home in the first place).

The most important factor to remember with rent-to-own is that all terms of the contract or option must be spelled out to the smallest detail to avoid any problems. Who is responsible for repairs to the home? Who is responsible for maintenance? What happens if the buyer misses a payment? When is a late fee added? When is the down payment refundable, or at what point does it become non-refundable? Are pets or roommates allowed? Who is responsible for paying property tax and insurance? These are just a few of the important questions buyers and sellers should consider and work out prior to entering into an agreement.

It's not hard to see why hiring a lawyer to review a land contract or "option to purchase" agreement is a very good idea. There are so many details and potential issues that need to be covered that it is almost impossible for people to set these up correctly without professional guidance.

A painstaking preparation setting up a land contract or option-to-purchase will help prevent a lot of problems down the road. And even with proper legal and real estate guidance, know the risks. Although this type of transaction is a little more complicated than some of the others, it helps prospective buyers become homeowners. Sellers will be happy they are out of the property and pleased to have renters who may take better care of the home than would renters with no stake in it. And still, traditional mortgage to buy and sell the home may still be worth the wait.

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