The Basics on Lease-Option (Rent to Own)

Posted by ForSaleByOwner

tenants getting their keys for their rent to own property

Are you eager to buy a home but need some time to build up your savings and credit score? Or maybe you’re a home seller who hasn’t received any offers to your liking. Either way, a lease-option – otherwise known as a rent-to-own lease – can be the ticket to achieving your goals. Check out what’s involved and some of the pros and cons to see if it might be right for you.

How Does a Lease-Option Contract Work?

A lease-option is made up of two agreements. The first is a standard lease, which means a tenant rents a home and pays monthly rent and expenses to a landlord. The second agreement is the “option,” which locks in certain terms that allow the tenant (home buyer) to buy the home from the landlord (home seller) when the lease term ends. These can be combined in one document or exist separately. Learn some of the finer points of each agreement below.

The Lease Agreement

A lease agreement is a contract between a lessor and lessee that allows the lessee to use a property for a designated amount of time. This agreement does not provide any ownership rights to the lessee, and as with any lease contract, most points are negotiable. However, there are some standard practices for the basic conditions, including:

The Lease Term

Most leases are set up to last one to three years. Buyers usually prefer longer terms – even as many as five years – because it gives them more time to strengthen their credit score and save for a down payment.

Repairs and Maintenance

Tenants are typically required to keep the home clean and pay for any damage caused by neglect. Damage is often less of a concern with lease-option homes because many tenants plan on owning the home after the lease expires.

Occupancy Limits

The agreement should clearly indicate who the lease-option home is for. Most of the time it will be for the tenants who signed the agreement and any minors.

Security Deposits

It’s important to decide upfront how security deposits will be used and returned at the end of the lease. Usually the money is used for repairs (not for rent). The remainder is typically returned after the lease expires, minus any nonrefundable fees, like cleaning expenses.

The Option Agreement

This portion of the contract gives the tenant the right to purchase the rental property once the lease ends. As part of this guarantee, the tenant and homeowner must agree on several key points:

Purchase Price

The tenant and landlord can agree to a purchase price or decide that the home will be priced at market value once the lease ends. Most tenants prefer locking in a price from the start since home prices generally go up. Plus, knowing the price ahead of time makes it easier to plan out a monthly budget and save for a down payment.

The Option Fee

Tenants must pay extra to rent with the option to buy, which is where the option fee comes in. Landlords often seek 1-5 percent of the purchase price. Whatever amount is agreed upon, it can be paid upfront or over the course of the lease as a part of the monthly rent. Depending on the agreement, some of this money can also be applied to the home purchase. Option fees are typically nonrefundable if a tenant decides not to purchase the home.

The Option Period

This is a time period when a tenant can exercise their option to buy the lease-option home. In some contracts, the tenant can do so at any time during the lease. In others, it must be at a date specified in the agreement. Once the option period passes, the option agreement is null and void, and the tenant typically forfeits the option fee to the landlord.

Keep in mind – if you’re a tenant debating whether to exercise your option, you should still use the same best practices as any home buyer. Just because you’re familiar with a home and have an arrangement with the home buyer doesn’t mean you should cut corners or limit your options.

Is a Lease-Option a Good Idea?

There are pros and cons to a lease-option for both the homeowner (landlord) and potential buyer (tenant) of a house. Whichever side you’re on, it’s highly recommended that you hire a real estate attorney to draft the necessary documents and learn about your rights.

Pros

If you’re a home seller, offering a lease-option allows you to expand your list of potential home buyers. Everyone who needs more time to secure a mortgage is suddenly a candidate, so you can sell a home that you might not have been able to otherwise. You’ll also receive the financial benefit of monthly rent and the option fee (refundability is negotiable). This means you can potentially turn a bigger profit than if you simply sold your home to begin with.

As a home buyer, the biggest advantage is getting to move into a desirable home while getting some extra time to qualify for a mortgage or sell your current home. If the purchase price for the lease-option home is agreed upon up front, you can also save on the purchase price if the home appreciates in value by the time your lease ends.

Cons

If you’re the home seller, a lease-option means that you’ll need to become a landlord with traditional landlord worries. You’ll need to address the tenant’s needs, make repairs and collect rent, all of which takes time and involves risk. There are also financial risks. A lease-option may create a potential cloud around the title should the tenant not purchase the home. And if the tenant does walk away, a homeowner must then invest more time, energy and money to try and sell the home all over again.

There are risks on the tenant’s side, too. If you’re a tenant who does not end up buying the home for whatever reason, the option fee will likely be lost. Whether because things don’t work out as planned or the housing market takes a turn for the worse, you may also be forced to choose between sacrificing your option money or buying a home for more than it’s worth. In addition, a landlord may stop making mortgage payments and lose the home, which might toss you into legal turmoil.

For more on the advantages and drawbacks of lease-options, see For Sale By Owner’s guide, Rent-to-Own your home: Pros and Cons.

Where to Find Rent-to-Own Listings?

Many homes are designated as rent-to-own by owners and can be searched for directly online.

If you’re interested in a lease-option to buy a home, you may need to seek out homeowners who have started renting out a property because they were unable to attract an offer at their asking price. There is also a growing number of lease-option homes in pricey loan markets like San Francisco and New York, where many residents find it difficult to secure a mortgage even if they have adequate credit and substantial savings.

The Bottom Line

Sometimes it’s tough for buyers to find financing and sellers to find buyers. A lease-option can solve for both and is worth exploring if you’re stuck in real estate limbo. Just remember, before you sign a lease-option agreement it’s essential to consult a qualified real estate attorney who can clarify the contract and answer your questions.