The Lease Option: A Buyer’s Perspective
A lease option is a technique that many potential homes buyers could get into a home without actually buying the home … yet.
In this article we will cover how a lease option works from the perspective of the buyer, (a.k.a., tenant/buyer).
What is a Lease Option?
A lease option is also called rent to own (a.k.a., rent-to-own). Essentially, it is renting a home with an option to purchase the home within a specified time frame.
It is not ownership but it is the intent on ownership in the not so far future.
The Terms and Specifics
There are a few terms you will need to be aware when entering into one of these contracts.
Set Purchase Price
The price of an option is based on many factors. These factors can include what is currently going on in the real estate market and could also include a forecast of what is expected to be happening in the next couple of years.
All real estate markets are cyclical. These cycles depend on what part of the cycle the market happens to be in and what it is forecasted to be.
Normally a purchase price is set to a specific dollar amount. This has to be agreed upon by both the seller and the buyer to be a valid contract.
Appraised Value Purchase Price
I have seen the purchase price to be set upon a future appraisal of the contract. I believe this may not be a valid form of contract since an exact price was not agreed upon. A lot can happen in the future if using an appraised value and the market goes significantly above or below that expected value.
As an example of using appraised value where one side is unfairly affected. Assume the current value of a home is $250,000. Both parties assume market prices are going up gradually and decide to go off appraised value. Buyer and Seller assume the future price is going to be somewhere in the $280,000 range.
Then something happens that nobody foresees and the price jumps to $350,000. If the buyer was thinking $280,000 there is a very good chance they may not be able to afford such a dramatic increase in values and he is now disqualified from buying.
Or in the case of a market reversal and the market plummets to $180,000. If the seller still owes anything above that then she will have to come out of pocket if the buyer decides to take advantage of the lowering prices, as was seen across the nation during the recent recession.
Thus, setting a price not only protects both parties, and it also gives the buyer the target value to be able to qualify for a loan.
The option payment is the payment you will make at the beginning of the process that secures your right to purchase the home in the future.
Some people reference this term as a “down payment”. This is actually an incorrect substitution. A down payment is part of the purchase process in real estate. An option payment is a payment for an option to purchase.
This option payment is usually fully applied toward the purchase of the home either as a direct reduction in price or is applied as a seller’s concession toward the buyer’s closing costs and down payment, or combination of both.
This payment can vary greatly. The seller wants a high number while the buyer will want a low number. They will have to agree somewhere in the middle.
With the years I have been in the business I have seen this value range from 2% to 10% or even higher. This is based off the purchase price, as mentioned above. Suffice it to say that a healthy range can be around 3% to 5%. It is significant for the buyer and is usually twice a security deposit would be.
The option payment is almost always non-refundable. This is the risk a buyer will be taking in order for the seller to take the home off of the market.
An FHA loan for owner occupants begins at 3.5% and thus if the buyer already paid 3% then they are close to their down payment when they decide to purchase.
The rent credit is the amount each month the buyer will receive from their monthly rental payment. It is determined by the base rent for the home is for that area.
The rent credit is added to the base rent for similar homes in the area (i.e., comparables or “comps”). The amount added will range depending on the area of the country and the desirability of the community.
In my experience, I see it as low as $100 and can go upwards of $500 or even higher. The rent credit is an additional payment paid in addition to the rent. When rent is paid on time this rent credit will be given back to the buyer as a seller’s concession.
Here is an example. Let us say the market rents for an area is $1200. Let us say it is a pretty desirable community. The landlord/seller may ask for $1400 per month but is willing to credit $200 ($1200 + $200) to the tenant/buyer. Thus, when the tenant exercises his option he would have $200 per month he was in the home. If he was in the home for 20 months this would be (20 * $200) $4,000!
Length of Contract
The length of a lease option contract can also vary depending on location and desirability.
In my experience, most lease option contracts are at least one year long and typically go out to two years.
The average is normally around two years. This is related to people who have done a short sale or bankruptcy recently and usually have to wait that much time before they are able to purchase again due to lending restrictions.
I would say to go as long out as possible even if you only need a shorter time frame. This would cover any unforeseen issues that may pop up. Thus, if you think you need 6 months, go for 1 year. If you think you need one year go for 18 months to 2 years. Any potential issues are covered by this additional time.
A lease option is a great way to get into a home when you are not able to qualify for a loan at a particular time.
Now that you know what to look at it is now time to start saving your money and improving your credit.
And always know your credit score. If you don’t speak with a lender first you can go to My FICO to get your actual FICO score.