Guide to lease options and owner financing: Are rent-to-own homes a good idea?
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What do you do when you want to buy a home right now but you can’t get financing? One option could be rent-to-own homes, also known as lease options.
- Lease options allow you to set a purchase price and move in now while completing the process and closing in the future
- Rent-to-own homes involve both a lease (rental agreement) and a purchase contract
- Lease options require you to pay money to the seller that you could lose if you don’t complete the purchase
Other rent-to-own home schemes
Some sellers finance the sale themselves and also call the transaction a rent-to-own home. It’s similar but different. Renting to own may get you in the door faster, but lease options are full of pitfalls. Understand the pros and cons of rent-to-own homes and owner fiancing to make your attempt at homeownership a success, and avoid expensive errors.
What is a lease option, exactly?
A lease option is a contract that involves both a rental and a purchase agreement. You and the landlord/seller establish the price you’ll pay for the home upfront, and you’ll complete the purchase in the future if all goes as planned.
In exchange for allowing you to purchase a home in the future at today’s prices, the seller usually requires a substantial option fee, an above-market rental rate, or both.
A lease option should contain several elements:
- Purchase price: what you’ll pay for the home when you close at some future date
- Term: the number of months the contract will be in force — in other words, how much time you have to complete the purchase (typically one to three years)
- Option fee: an upfront payment that becomes part of your down payment if you complete the purchase (typically 1 percent of the purchase price)
- Rent credit: additional above-market rent paid to the seller, which becomes part of your down payment if you close on your purchase (typically a 10 – 15 percent increase over market rent)
Your contract also contains rental provisions:
- Due date of rent, and penalties for late payments
- Approval of pets, roommates, and modifications to the premises
- Rules about noise, parking, and other behavior
Note that as long as you close on your purchase, the extra money you pay goes toward your down payment. However, if you choose not to or otherwise fail to close according to your contract, you forfeit all that cash to the seller.
Lease option advantages
- When home values are escalating, you lock in today’s price and buy later.
- Rent credits force you to save a down payment for your home.
- You can avoid a move by renting and then owning the same house.
- You may be able to purchase even if you don’t qualify for a traditional mortgage.
What is seller financing?
With seller financing, you actually complete the home purchase and don’t have a rental agreement. Your financing term may range from a few months or years to a full 30-year mortgage.
You make regular monthly mortgage payments to the seller until you can refinance the property, pay off the loan or sell the home.
Seller financing can save you on lender fees, or it can get very expensive. Your interest rate, for instance, may be significantly higher than that offered by traditional lenders. On the other hand, the seller may be willing to finance you when traditionally lenders take a pass on your application.
Your contract will specify both the terms of the purchase (what’s included, how much you’ll pay, and a closing date), and the terms of the loan (the interest rate, payment, due date, late penalties, the length of the loan, and more). Note that many consumer protections that apply to mortgage companies and banks do not apply to private or owner financing.
Seller financing: both eyes open
It’s important to protect yourself when buying a home with seller financing. Do what a traditional lender would to protect its investment. Many buyers are so happy to find a seller who will finance them that they fail to make sure that the property is a fair deal. Often, it’s not worth anything close to the asking price, or it may require extreme renovations to be safe or livable.
- Pay for an appraisal from a licensed appraiser you choose yourself, or a brokers price opinion (BPO) from a licensed real estate broker
- Order and pay for a home inspection
- Obtain a title report and get an owner’s title insurance policy. That’s much cheaper than the lender’s policy required by traditional mortgage lenders, and it protects you, not the home seller
- Use an escrow company or attorney to hold all funds on deposit until the property formally changes hands
- Record the sale with your County Recorder’s office
You should also review the cautions about lease options in this article because many of them also apply to owner-financed properties. Remember also that in addition to your monthly mortgage principal and interest, you’ll be paying for homeowners insurance and property taxes, and perhaps homeowners association (HOA) fees.
Get these amounts in writing and make sure that the entire payment is affordable, or you could lose everything.
Why lease options fail
- Home value appreciates higher than sellers expect, and they refuse to sell.
- Home value is lower than sales price, and the tenants decide not to purchase.
- Tenants cannot qualify for a mortgage to complete the purchase.
- Tenants breach the contract and sellers cancel the sale, keeping option money.
Lease options: mistakes to avoid
A rent-to-own or lease option is a contract that you can use to purchase a home in the future in terms you agree to today. If you fail to comply with, or “breach” the terms of the agreement, the seller can kill the whole deal and often keep your money, too.
Make sure the contract is acceptable to your future mortgage lender
If you don’t word the agreement correctly, many mortgage lenders won’t recognize that down payment you have so carefully amassed. You need to craft your purchase and rental agreements correctly and keep careful records to make sure that this does not happen.
Suppose that you paid an upfront option fee of $5,000, and during a two-year period added another $5,000 in rent credit. If your purchase price is $200,000, that’s a 5 percent down payment.
However, if you and the seller make mistakes when drafting the lease option, the lender won’t count that $10,000 as a down payment. Instead, it will assume the purchase price is $190,000, and it would take another $9,500 down to get a 95 percent loan.
Don’t risk it. And remember, that while the seller might draft the agreement, it’s you who will lose your money if you cannot get a mortgage and complete the purchase during the lease term.
Be very sure that you’ll be able to purchase the property within the lease option term. If your credit is not good enough or you lose your job, everything you’ve worked for to buy the home could be lost.
How to draft a lease option
Fannie Mae guidelines allow rent-to-own homes. Here’s what they say:
Rent credit for option to purchase is an acceptable source of funds toward the down payment or minimum borrower contribution. Borrowers are not required to make a minimum borrower contribution from their own funds in order for the rental payments to be credited toward the down payment.
Credit for the down payment is determined by calculating the difference between the market rent and the actual rent paid for the last 12 months. The market rent is determined by the appraiser in the appraisal for the subject property.
The lender must obtain the following documentation:
- A copy of the rental/purchase agreement evidencing a minimum original term of at least 12 months, clearly stating the monthly rental amount and specifying the terms of the lease.
- Copies of the borrower’s canceled checks or money order receipts for the last 12 months evidencing the rental payments.
- Market rent as determined by the subject property appraisal.
The appraisal and rental schedule
To make sure your rent credit is eligible for use as a down payment, then, have the seller set rent above the property’s fair market rental rate. You will need to prove that your rent is above market, and the agreement should state the amount of your payment that covers rent, and the amount that constitutes rent credit.
A licensed appraiser can help you determine how much this should be by completing a rental schedule. You should be commissioning an appraisal anyway before entering this agreement. Adding a rental schedule does not increase the cost by much.
Also, maintain meticulous records of your rental payment history. You will need it for your mortgage application, and it’s unwise to rely on the seller to keep such records for you.
The document should clearly state that the option fee will be credited toward the down payment, not toward reducing the price of the home. If you work from a template from a reputable source, you won’t have “sneaky” provisions buried in boilerplate.
Avoid troublesome terms
It is not uncommon for the landlords/sellers to include a clause allowing them to keep your monthly rental credit if your payment is late. If that’s in there, be very, very careful about making your payment on time and proving that you did. Arrange a backup plan in case you’re short one month — have an emergency fund or a line of credit you can tap.
In one example of a lease option agreement offered up by the University of Utah, the tenant/buyer could breach the agreement merely by using “offensive language” around nearby residents. Imagine trying to sort out in court what constitutes “offensive” language if you get kicked out!
Make sure the term is long enough that you’ll be in a position to finance the property with a regular lender, and that you’ll be able to afford the payments.
Some unscrupulous sellers actually don’t want you to complete the purchase, according to a study by the nonprofit National Consumer Law Center. For example, some include clauses allowing sellers to cancel the deal and keep all of your option money and rental credit for being late with a single payment.
You may be obligated in your agreement to cover maintenance and repairs that normally would be the landlord’s responsibility. Again, if you cannot do so, you could end up forfeiting your money to the seller.
One study found that only about 20 percent of rent-to-own home contracts actually resulted in a completed sale. Otherwise, the would-be homeowners moved out, losing their money, or ended up in foreclosure with mortgages they could not afford or homes that were worth less than they paid.
Retain a lawyer or be broke and sorry
Because lease option or owner-financed contracts don’t typically involve mortgage lenders, and because they can feel less formal than a traditional sale, it can be tempting to forgo the legal representation.
Don’t. Lease options and owner financing involve a lot more risk to the buyer than traditional transactions.
Hire a real estate attorney to work on your behalf. The seller is likely to have someone clever doing the same thing, and ignorance can be very costly to you.
Your attorney can review your agreement with the seller and identify clauses that could unfairly cancel your option or your right to purchase the home.
An attorney can also look at county records to make sure that the home you’re planning to purchase is not in foreclosure, saddled with liens, or owned by somebody other than the seller.
You should also have your lawyer record your lease option or purchase with your County Recorder. This will prevent the seller from transferring the property while it’s under contract to you. It will also prevent the seller from acquiring additional mortgages against the property without your knowledge.
Alternatives to lease options
With all the pitfalls of lease options, and the high failure rate of rent-to-own homes, why would anyone go through this?
- Newly self-employed applicants often can’t get mortgages until they have at least two years of successful business ownership
- Established self-employed applicants may have extensive write-offs that kill off their qualifying income
- Applicants with recent foreclosures or bankruptcies face waiting periods with many traditional mortgage programs
- Many renters still believe that they need a large down payment to finance a home and don’t try for ordinary financing
Most of these hurdles can be overcome with government-backed or portfolio mortgage products. They may be much safer and easier than rent-to-own options.
If you’re self-employed in a completely new field, you’ll probably need a two-year track record. However, the two-year rule can be fudged in some circumstances, according to Fannie Mae:
Fannie Mae generally requires lenders to obtain a two-year history of the borrower’s prior earnings as a means of demonstrating the likelihood that the income will continue to be received.
However, a person who has a shorter history of self-employment — 12 to 24 months — may be considered, as long as the borrower’s most recent signed federal income tax returns reflect the receipt of such income as the same (or greater) level in a field that provides the same products or services as the current business or in an occupation in which he or she had similar responsibilities to those undertaken in connection with the current business. In such cases, the lender must give careful consideration to the nature of the borrower’s level of experience, and the amount of debt the business has acquired.
What about self-employed buyers who are established, but who write off a lot of their gross (before tax) income? There are “bank statement” programs for them. These loans vary by lender, but in general, the applicants submit 24 months of bank statements. The lender averages the deposits to determine the income available for mortgage repayment.
Interest rates for these programs is a little higher. But in exchange, much of the risk you’d assume by purchasing with a lease option or owner-financed contract goes away. The lender takes it on instead, and that’s worth a lot.
Applicants with credit problems
If your credit isn’t good enough for a mortgage today, be careful. By taking on a risky or unaffordable lease or mortgage payment, you’ll be going from bad to worse. Seek the advice of a non-profit credit counselor before jumping into more debt.
If you have a low credit score, but not necessarily bad credit, you may be able to get mortgage approval. Try a government-backed mortgage like FHA. You have a decent shot at approval if you have paid your obligations as agreed for at least the last 12 months. With FHA, your FICO can be as low as 500 with 10 percent down. But with a score that low, your chances are not great.
And if your credit is shot, but your income and down payment are high, non-prime lenders will finance you. You can have FICOs as low as 560 for many of these and you might have discharged a bankruptcy yesterday. These might be great choices if you can improve your position and refinance in a year or two. Or if you plan to flip the house and don’t care if the interest rate is high.
Applicants with no down payment
No one should be barred from homeownership if down payment is their only issue. Note that many options have income limits, but those limits are probably higher than you expect.
Here is a very quick rundown of options:
- Piggyback mortgages (combining a first and second mortgage to buy a home)
- Good Neighbor Next Door (program allowing first responders and teachers to buy homes at half price with just $100 down)
- Down payment assistance from charities, state and local governments, and employers
- Fannie Mae and Freddie Mac 97 percent loans with Community Second mortgages up to 105 percent of the purchase price
- Mortgage programs like FHA allowing down payments to be loaned or gifted from family members or 401(k) accounts
- Seller concessions that cover closing costs or buy you a lower interest rate
- USDA loans provide 100 percent financing in rural areas. Low-income buyers can get subsidized rates as low as 1 percent
- VA home loans can finance 100 percent of the purchase price without monthly mortgage insurance
What are today’s mortgage rates?
Today’s mortgage rates depend on the program you select and your strength as a borrower. Regardless of your situation, it makes sense to sit down with a good loan professional before resorting to riskier rent-to-own homes. If you choose a rent-to-own or lease option, treat it like a lender would. Protect yourself with legal advice, appraisals, inspections and make sure your transaction is publicly-recorded.Verify your new rate (Sep 24th, 2020)
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