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Considering a lease/option versus a purchase

By From page HMS2 | March 15, 2014

Q: What is better? Rent-to-own or purchasing a home without rent-to-own? My best friend says you can get into rent-to-own with 1 percent down, but is it more beneficial for a person that is trying to restore their credit?

A:  That’s a very timely question.

Historically, rent-to-own was pretty much confined to purchasing cheap furniture and televisions.

Recently I’ve seen more advertisements where investors are offering such an arrangement for potential homebuyers. The concept is as old as real estate itself and has always been common in commercial properties where buyers tend to be more legally sophisticated, or who commonly have contracts reviewed by attorneys.

In the residential world, this type of transaction carries the potential for danger and abuse.

You can call it “rent to own,” or anything else you like, but let’s see this for what it really is.

There are an infinite number of variations to what is really known as a lease/option agreement, which is what we’re talking about. The general idea is a tenant signs a lease that carries with it an obligation that the landlord sell the property to the tenant at a future time, if the tenant so chooses.

The lease part is obvious. It’s simply a landlord and tenant relationship.

The “option” portion is called that because it gives the tenant the option to exercise the purchase contract at a future date.

In a commercial context, such an arrangement could be of value to the tenant who doesn’t know if their business is going to be successful. They want a few years to run the business from that location and, if everything works out, they can buy it. If not, their lease expires and they walk away.

Or, the tenant could be playing the market, much like a stock option. If property values go up, they’ll exercise their option and buy for a below-market price. If prices go down, they’ll walk away.

With a home the dynamic is usually different.

The tenant and prospective homebuyer dreams of buying a house but either their credit or income, or both, don’t allow them to get a mortgage right now. But they see that changing in the future. Maybe they’re afraid home prices will rise and by the time they can get a loan they’ll be priced out of the market.

In the commercial world, the tenant generally pays a significant amount of cash, above and beyond the rent, to the owner to hold the option. It’s called option consideration.

Typically, though not necessarily, if the tenant ultimately exercises their option the money they paid goes toward the purchase price. If not, the owner keeps it as his compensation for tying up ownership for several years.

Most residential lease/options involve tenants without a lot of cash. So the common variation is the tenant agrees to pay above-market rent with the extra monthly amount being credited toward the purchase if the tenant exercises their option. If not, the landlord/owner keeps it.

It may be that your friend’s “1 percent” number is really option consideration they’d expect you to pay to the owner for your option.

From a financing perspective, the mortgage company is going to expect you to pay the same down payment that everyone else whose getting one of their loans has to pay. So if you need 10 percent down to get the loan, you’re still going to have to come up with the other nine percent.

From my experience, most tenants who are sure they’ll be able to get a loan in the next two years fail to do so.

I’m not trying to be pessimistic here, just real.

If you start out with no savings, and a majority of your income goes to paying the rent, how will you have the $20,000 or more you’ll need to get a home mortgage in two years? If you lost a house last year to a foreclosure and your credit score is in the 500s, how will you get it up into the mid-700s in two years?

That’s not to say it couldn’t happen. It’s only to point out that someone entering into a lease/option should think long and hard about it.

Failure to be able to exercise your option before it expires would likely mean you’ll lose either the cash you paid up front or all of the added rent you paid over the years.

Tim Jones is a real estate attorney in Fairfield.  If you have any real estate questions you would like to have answered in this column you can contact him at [email protected]

 

Tim Jones

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