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Understanding Lease-to-Own Home Transactions

The Mortgage Professor: Another look at lease-to-own house purchases

Nov. 5, 2015

By JACK GUTTENTAG The Mortgage Professor - Tribune News Service


A lease-to-own house purchase, henceforth LTO, is a lease combined with an option to purchase the property within a specified period, usually three years or less, at an agreed-upon price.

In recent years, I have written several articles on the topic and they are among the most read of the many hundreds of articles on my website. The reason is that they offer the hope of home ownership to many wannabe owners who can't meet purchase requirements in any other way; and they offer many wannabe home sellers who have been frustrated by the market's lack of interest in their home an opportunity to sell at a more attractive price than is otherwise available.


Weaknesses of Buyers and Sellers
Both participants in LTO transactions do so because of weaknesses.

In the case of buyers, the weakness almost always is that they are unable to qualify for the mortgage they need to finance a purchase. They may have a foreclosure on their record that they must wait out or their credit score may be too low to meet lender requirements.

The LTO offers such consumers an opportunity to bet on themselves. The bet is that before the option period expires, they will qualify for the mortgage they need to exercise the purchase option.

During the option period, the foreclosure waiting period passes, and they have the opportunity to raise their credit score while living in the house.

In the case of sellers, the weakness is an inability to sell at what the owner considers the correct value.

This could be because property values in the area in which the property was located had declined.

In such case, the LTO offers the prospect of being able to sell in the future at a substantially higher price than is available today.

Another possible weakness that has become important in recent years is that the condition of the house is poor and the owner does not have the means to fix it. An LTO buyer is likely not to be so fussy about the condition of the house, and may be positioned to fix the deficiencies during the option period.


Important Contractual Provisions of a Lease-Purchase Transaction
In a typical arrangement, the borrower pays an option fee, one percent to five percent of the price, which is credited to the purchase price.

The borrower pays a market rent, and an additional rent credit payment that is also credited to the purchase price.

The option fee, option period, rent, rent credit payment, and purchase price are all negotiable items. If the purchase option is not exercised, the buyer loses both the option fee and the rent credit payment.

The option fee and rent credit payment are viewed differently by buyers and sellers. To the buyer, they are part of the equity in the house they fully expect to own. To sellers, however, these payments are the best guarantee that their houses will sell; if they don't sell, the payments are retained as income.

That the benefit to the seller generally exceeds the cost to the buyer makes the lease-to-own deal a possible win-win.

The rent credit payment, which is unique to LTO deals, is an amount above the market rent paid by the buyer, which is credited back to the buyer at closing. Rent credits can be used in two different ways which are not always distinguished.

The simplest approach reduces the sale price at closing by the total rent credit paid by the buyer. This reduces the required down payment only slightly.

For example, if the sale price is $100,000 and the rent credit totals $5,000, the sale price becomes $95,000 and the down payment required at 5 percent falls from $5,000 to $4750.

The rent credit is much more useful to the buyer if it can be used for the down payment in its entirety. If the rent credit of $5,000 in the example above is used in this way, the price of the house would remain at $100,000 but the buyer would receive $5,000 from the seller at closing which could be used as down payment.

For this to work, however, the lender must accept the rent credit as legitimate savings by the buyer. To be sure that the rent credit is an amount paid above a fair market rent, the lender will require that the market rent be documented by an appraisal. To be sure that the buyer actually made the payments, the lender will want to see the cancelled checks that evidence the payments.


About the Writer
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.

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Copyright (c) 2015, The Mortgage Professor

Distributed by Tribune News Service.


This story was distributed by TNS - Tribune News Service
 
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