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Is a Lease-to-Purchase Option Really for You?

Written by Posted On Monday, 30 September 2013 03:18

Are you’re tired of renting? Do you want to buy a home of your own, but haven’t saved any money? Is your credit history ‘less than stellar’ and you haven’t been able to qualify for a mortgage?

When some people are in this situation, they often look for alternative ways to buy a home. One alternative they sometimes turn to is renting a home with an option to buy (also known as a lease-to-purchase option). With a lease-to-purchase option, you rent a home and have an option to buy that property at the end of the term of the lease.

A lease with a purchase option can be a useful way to buy a home. But it’s not for everybody. In fact, the majority of lease-to-purchase options do not end with the renter buying the home that they’re renting. Sometimes it’s for a good reason. But it’s also a waste of money.

When you rent a home with an option to buy later, you will have to pay both an ‘option fee’ and a ‘rent premium’.

The option fee is an upfront fee the renter pays the seller of the home. The option fee is required to make the contract both valid and binding. The option fee can be small (equal to say two or three month's rent), or it can be as much as 3 - 5% of the purchase price of the home. If you decide to buy the house at the end of the lease term, then all of this money goes go towards the purchase price (the down payment) on the home.

A rent premium is the amount of money that is over and above the typical rent for the area for the size and type of home you want to buy. In addition to the option fee, that portion of your rent payment ─ or the rent premium ─ will also go towards the down payment on the purchase of the home.

Here's an example of how a lease-to-purchase option works:

Let’s say the house you want to buy is worth $250,000. In order to make the lease-to-purchase agreement valid, you need to add in an option fee. It could be 4% of the purchase price, or $10,000, in this case. Next, you would account for the monthly rent premium. Let’s say the typical rent is $1,500 a month for the type and size of house you want to buy. Because you’re doing a lease-to-purchase option, you might pay $1,750 a month in rent. The extra $250/mo is the rent premium. On a two-year lease, you would earn $6,000 in rent premium credits ($250/mo x 24 months). When you combine both the option fee and rent premium credits, you will have accumulated $16,000 over 2 years that is to be used for the down payment on the purchase of the house.

If you don’t exercise the option to buy the home at the end of the lease, you don't get any of the option money or rent premiums back ─ even if you lost your job, got sick and couldn’t work, or had to move. In this case, you will have shelled out an additional $16,000 over the market rent of $36,000, or a total of $52,000, for doing nothing more than renting a home over 2 years. That comes out to $2167/mo! Can you really afford to lose all that money?

If you’re still thinking about a lease-to-purchase option as a way to buy a home, you will need to answer for yourself a few questions before you sign the agreement:

  1. Can you afford the extra monthly rental premium payments on the lease? Remember, the monthly payments on a lease will include both the fair rental value for the home plus a rental premium. The rental premium will go towards the purchase of the home. Thus, the monthly payments under a lease option will usually be more than you would pay if you were just renting the same house.

  2. Will you be able to make the monthly payments on the home and meet the other expenses of home ownership? Who would be responsible for fixing the leaky roof in the middle of the night? How about a broken pipe that is leaking water into the basement?

    All those repairs that used to be somebody else's problem while you were renting an apartment suddenly becomes your responsibility ─ even during the period that you’re renting the home. Whether it means climbing on a ladder to repair the roof shingles or having to pay for a new hot water heater when the old one breaks down, you will have to take care of it. Even if you are able to get a mortgage for the home, it won't do you any good if you can't afford to keep up with the expenses of owning it. Be sure to factor in not only the mortgage payments, but other expenses that renters typically don’t have to pay such as property taxes, insurance, and maintenance and repairs costs.
  3. Do you plan to stay in the area? Because a lease with an option to purchase costs more than simply renting a home, you should be fairly certain that you will stay in the area and that you want to buy that house at the end of the term. If you don't buy the house for whatever reason, not only do you lose your upfront option fee, you will also lose any additional money ─ or rent premium ─ that you paid over and above the fair rental value of the home. In addition, you will not recoup any of the maintenance and repair costs you incurred while you were living in the home.

  4. Will you be able to get a mortgage at the end of the lease term? In some cases, the seller will finance the purchase of the home after the lease option. Most of the time, however, the buyer will need to find his or her own financing by applying for a mortgage. Because of the money already laid out for the option fee and the rent premium that will be used towards to purchase of the home, a lease option can help you get a more favorable home loan than you otherwise could, but that's no guarantee.

    You may be able to say you can get a mortgage now, but you also need to bear in mind that over time, things can happen:
    • What happens if you lose your job or your work hours are sharply reduced?
    • What happens if your spouse who works full time ─ and whose income you partially relied on the help qualify for the mortgage so you can buy the house ─ is no longer able to work?
    • What happens if you have to file for divorce and have to pay alimony and child support?
    • What happens if you got sick or injured and can’t work for a period of time?
    • What happens if you incur hefty medical expenses that your health insurance won’t cover?
    • What happens if you can’t pay your bills and your credit scores deteriorate?
    • What happens if you had to file for bankruptcy?
    • What happens if the septic system fails and you can’t afford to make the repairs?
    • What happens if the house appraises for less than the agreed upon purchase price?

Any of these items can cause your mortgage application to be denied, thereby preventing you from exercising your option to purchase the house. Regardless of the circumstances involved, if you can’t qualify for a mortgage and if you otherwise don’t have the financial resources to buy the home, you will still lose both the upfront option fee and the rent premiums that you paid out.

Risks to Homebuyers

As with any business transaction, just as there are rewards, there are risks involved. For many people, a home will be the biggest purchase they will ever make. Homebuyers should carefully weigh their options before agreeing to any binding agreement ─ especially a lease-to-purchase agreement.

Let's look at some of the risks a lease-to-purchase agreement has for buyers:

  • Buyers will have to pay an upfront option fee. It's usually a percentage of the agreed-upon selling price of the home, and is often thousands of dollars. Although this money will go towards the down payment should you decide to buy the house, that money will be lost if you don’t exercise your option to buy the house ─ regardless of the circumstances,

  • With most lease-to-purchase agreements, if you’re just one day late on a month's rent payment, the rent premium credit will be voided for that month. Instead, it becomes a ‘late fee’. Think about the above example, where the two-year renter received a $250 rent credit each month. If you paid the rent late just three times each and every year, you will be short $2,250 for the down payment at the end of the lease period. The buyer in a lease-to-purchase agreement must pay the rent on time, every time.

  • Depending on the agreement, renters can walk away if they find something seriously wrong with the house. Although you will lose the option fee and all that rent premium money you paid out, that amount lost could be much less than if you had bought the house outright and tried to leave it later.

  • If the seller fails to pay the original mortgage on the house, it may be foreclosed on by the lender and you will be forced to move. And, no, don’t expect the lender to return the option fee or rent premiums to you.

  • At the end of the rental period, you still may not be able to buy the home for the same reasons you couldn't buy at the start of the lease: bad credit, insufficient down payment, or insufficient income to qualify for the mortgage. You will have to find another place to live, and you can kiss that option fee and monthly rent premiums goodbye forever.

Given the risks involved in a lease-to-purchase transaction, you would be much better off if you started saving for the downpayment now instead of putting it into an option fee and rent premiums, Also, take the time to clean up your credit history and improve your credit scores. Then, when the time is right for you to buy a home, find a house that you want to buy and that is in an area that you want to live in. Not only should you look for a house that you like, but one that you can afford as well. If you really like this blog post, please comment below and/or share it with your friends.


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