Mortgage alternatives for home buyers who can’t get financing
What if you want to buy a home right now but you can’t get financing? One option could be a rent-to-own home, also known as a ‘lease option.’
- Lease options allow you to set a purchase price and move in now while completing the home buying process 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
There are some unique benefits that come with rent-to-own homes and lease options. But there are very real risks, too.
Here’s what you should know if you’re considering one of these alternative home buying options.
In this article (Skip to…)
- What is a lease option?
- Lease option pros and cons
- What is seller financing?
- Lease options: Mistakes to avoid
- Predatory sellers and scams
- Alternatives to lease options
What is a lease option?
A rent-to-own home or “lease option” is a contract that includes both a rental and a purchase agreement.
Renting to own means you make rent payments for a specific period of time. At the end of the lease period, you’d have the option to buy the home, potentially using part of your rent payments as a down payment.
You and the landlord/seller set the price you’ll pay for the home upfront, and then you complete the purchase in the future — if everything goes as planned.
In exchange for helping you buy a home in the future at today’s prices, the seller usually requires a substantial ‘option fee,’ an above-market rental rate, or both.
What’s included in a lease option agreement?
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% 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 the purchase (typically a 10-15% increase over market rent)
Your contract also contains rental provisions:
- Due date of monthly rent and penalties for late payments
- Approval of pets, roommates, and modifications to the premises
- Rules about noise, parking, and other behavior
- Your responsibilities in maintaining the home
Note that as long as you close on your purchase, the extra money you pay for rent and the option fee will go toward your down payment. However, if you choose not to buy the home after all, or if you otherwise fail to close according to your contract, you forfeit all that cash to the seller.
Renting to own may get you in the door faster, especially if you have credit challenges preventing you from getting a mortgage right now.
But lease options are full of pitfalls. Be sure you understand the pros and cons of rent-to-own homes and owner financing to make your attempt at homeownership a success and avoid expensive errors.
Lease options versus lease-purchase agreements
A lease-purchase agreement is another kind of rent-to-own contract. Lease-purchase is different from a lease option; instead of giving you the option to buy the home at the end of the lease, this contract requires you to buy the home at the end of the lease.
This requirement to purchase the home at the end of the lease period could create problems if you still can’t get a traditional mortgage loan at that time.
If you’re not sure whether your rent-to-own agreement requires you to buy the home at the end of the lease, be sure you ask a real estate agent or attorney for help before signing.
Lease option pros and cons
Unlike a lease-purchase agreement, a lease-option agreement gives you the right — but doesn’t require you — to buy the home after you make rent payments for a specified period.
Other advantages of a lease-option agreement include:
- When home values are escalating, you lock in today’s price and buy later
- Rent credits force you to save up 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
But there are distinct drawbacks, too. Some of the biggest risks that come with rent-to-own homes include:
- The home’s value may appreciate higher than seller expects, and they could refuse to sell
- The home’s market value could fall lower than sales price, and the tenants decide not to purchase
- Tenants may not qualify for a mortgage to complete the purchase at the end of the lease agreement
- Tenants could breach the contract and sellers cancel the sale, keeping the potential buyer’s option money
These are big risks. You should only enter into a lease option if you’re certain you’ll be able to get a mortgage at the end of the rental term — and that your home buying priorities won’t have changed by then.
In addition, make sure you’ve looked over the contract with a professional attorney or real estate agent, so you understand exactly what the terms mean and what will happen if the sale isn’t completed as planned.
What is seller financing?
Seller financing is different from a lease option or a rent-to-own home. With seller financing, you complete the home purchase upfront. But you don’t have a rental agreement or a traditional mortgage loan.
Instead, you make regular monthly mortgage payments to the seller until you can refinance the property, pay off the loan, or sell the home.
Your agreement with the seller may range from a few months or years to a full 30-year mortgage.
Seller financing can help you save money by avoiding lender fees, or it can get very expensive. Your interest rate, for instance, may be significantly higher than the rate traditional lenders could offer.
On the other hand, the seller may be willing to finance your purchase when traditional lenders take a pass on your application.
Your contract will specify the terms of the purchase (what’s included, how much you’ll pay, and the closing date), as well as the terms of the loan (the interest rate, monthly payment, due date, late penalties, the length of the loan, and more).
Note that many consumer protections and government regulations that apply to mortgage companies and banks do not apply to private or owner financing.
Unless you’re an expert on your local real estate market and on home financing, check with a Realtor or real estate attorney before buying a seller-financed home.
Risks of seller financing
It’s important to protect yourself when buying a home with seller financing. Do what a traditional lender would to protect its investment.
Because they are so happy the seller will finance them, many buyers fail to make sure 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 broker’s 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 above, because many of them also apply to owner-financed properties.
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.
Home buyers should get these amounts in writing and make sure that the entire payment is affordable. Otherwise, you could risk losing the home and the money you put into it.
Lease options: mistakes to avoid
A rent-to-own or lease option is a contract you can use to buy a home in the future at 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.
To prevent this worst-case scenario, make sure you’re taking the right precautions before entering into a lease option or rent-to-own agreement. Here are a few common mistakes to look out for.
Make sure the contract is acceptable to your future mortgage lender
If you don’t word your rent-to-own agreement correctly, many mortgage lenders won’t recognize the down payment you have so carefully amassed. You need to craft your purchase and rental agreements correctly and keep careful records to make sure this does not happen.
Suppose 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, this $10,000 in credit creates a 5% down payment.
However, if you and the seller make mistakes when drafting the lease option, the lender won’t count your $10,000 as a down payment. Instead, it will assume the purchase price is $190,000, and it would require another $9,500 down to get a 95% loan.
Don’t risk it. And remember: 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 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 banks to apply money you’ve saved up through rent payments and option fees toward a down payment on your new home loan.
But not all the money you’ve paid in rent will go toward the down payment, and you’ll need documentation to prove you’ve accumulated rent credit.
To determine your rent credit, a Fannie Mae-approved lender will compare the rent you’ve paid over the past year to the market value of rent during the same period.
An appraiser will determine the market rent. If the market rent is $15,000 and you’ve paid $25,000 in rent payments, the $10,000 difference could become part of your down payment.
Be sure you can provide the documents required to back up your case. These include:
- Your lease-purchase agreement showing a term of at least 12 months, the agreed monthly rent, and other relevant terms
- Canceled checks or receipts showing your actual rent payments for the last 12 months
- The appraisal showing the market rent during the same 12-month period
The appraisal and rental schedule
To make sure your rent credit goes toward your future down payment, have the seller set your rent above the property’s fair market rental rate.
You’ll need to prove later on that your rent is above market. The agreement should state the amount of your payment that covers rent and the ‘extra’ amount that constitutes a rent credit.
A licensed appraiser can help you determine how much to increase the rent payment 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.
Throughout the rental term, maintain meticulous records of your rent payment history. You will need these records for your mortgage application, and it’s unwise to rely on the seller to keep such records for you.
The agreement should also clearly state that the option fee will be credited toward the down payment, not toward reducing the price of the home. If you use a template from a reputable source, you won’t have “sneaky” provisions buried in the contract.
Avoid troublesome fine print
It is not uncommon for the landlords/sellers to include a clause allowing them to keep your monthly rental credit if you make late rent payments.
If that clause is included, be very, very careful about making your payment on time and proving 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 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 and your rent-to-own deal falls apart!
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 future mortgage payments.
Predatory sellers and rent-to-own scams
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 keep up this maintenance, you could end up forfeiting your money to the seller.
One study found that only about 20% 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.
Potential buyers should also be wary of scams. Before negotiating a rent-to-own deal, find out who owns the home through a title search or through tax records at the local courthouse.
If the person you enter a lease-option agreement with doesn’t own the property, you could be dealing with a scam artist who wants to steal your upfront money.
And make sure you see the condition of the home for yourself before agreeing to maintenance — especially if your purchase option depends on maintaining the home.
Be sure to retain a lawyer
Because lease options 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 legal representation.
Don’t. The rent-to-own process creates a lot more risk to the buyer than traditional transactions. You’ll need adequate representation.
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 — both upfront and later, at the end of the lease agreement.
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 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?
There are a few common reasons home buyers might think they can’t qualify for a mortgage and need to opt for a rent-to-own home instead:
- 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
- People with ‘fair’ or ‘poor’ credit often think their score isn’t high enough to get a mortgage
- Applicants with recent foreclosures or bankruptcies face waiting periods with many traditional mortgage programs
- Many renters still believe 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. These are often much safer and easier than rent-to-own properties.
Mortgages for self-employed applicants
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 avoided in some circumstances, according to Fannie Mae.
The agency will consider backing a mortgage for a self-employed applicant who has only 12 months of work experience if the borrower’s income tax returns show a comparable income prior to self-employment.
The tax records should show that the income from previous employment came in a field related to the borrower’s current self-employment.
What about self-employed buyers who are established, but who write off a lot of their gross (before tax) income?
There are bank statement loans for them. These mortgage programs vary by lender, but in general, the applicant must submit 24 months of bank statements. The lender averages the deposits to determine the income available for mortgage repayment.
Interest rates for these programs are 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.
Mortgages for people with low credit
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 still 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% down. Or, more commonly, you could get approved with a credit score starting at 580 and just 3.5% down.
If your credit is shot, but your income and down payment are high, non-prime lenders could potentially finance you. You can have a FICO score 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.
Mortgages with low and no down payment
No one should be barred from homeownership if making a down payment is their only obstacle. A variety of loan programs and options can help.
Note that many options have income limits, but those limits are probably higher than you expect.
Here is a very quick rundown of options:
- VA home loans — Allow 0% down payment for eligible veterans and service members
- USDA loans — Allow 0% down payment for low-to-moderate income buyers in qualified rural areas
- FHA loans — Allow 3.5% down payment and credit scores as low as 580
- Conventional 97 mortgage — Fannie Mae and Freddie Mac allow as little as 3% down if your credit score is at least 620
- Fannie Mae HomeReady mortgage — This loan program allows 3% down, and the home buyer can use income from other household members to help them qualify for the loan
- Down payment assistance (DPA) — State and local governments, as well as non-profits, offer grants and low-interest loans to help home buyers cover the down payment and closing costs. Research DPA programs in your area or ask your real estate agent or loan officer for help
- Seller concessions — The home seller is allowed to cover part or all of your upfront mortgage costs, if they agree to it
- Co-signers — If you have a friend or family member with excellent credit and/or income willing to co-sign your mortgage, you could qualify more easily. But use caution, because this person is putting themselves at risk of losing their credit score and savings if you can’t make your mortgage payments
Thanks to the wide variety of loan options and assistance programs, upfront funds are a much lower barrier to homeownership than they used to be. Often, it’s just a question of researching your options and finding the right strategy to buy your new home.
What are today’s mortgage rates?
Average mortgage rates are still near record lows, which means potential buyers could purchase homes with lower financing costs.
But your actual rate will also depend on your credit score, debt-to-income ratio, and the property you’d like to buy. Even if you think rent-to-own is your best bet, at least consider your chances of getting an actual mortgage loan.
It makes sense to sit down with a good loan professional before resorting to riskier types of rent-to-own options.
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.