Have you ever heard of a lease option?
This sales financing tool became popular in the late 1970s and early 1980s to circumvent alienation clauses in mortgages.
Alienation clauses prevent a borrower from transferring the loan obligation when they sell the property in the future.
While the lessee cannot transfer the lease to another party, they can purchase it themselves if they wish to.
Here’s what you should know about lease options and when you should exercise this right.
1. What is a lease option?
A lease option — also known as a lease with the option to purchase — is an agreement that allows the renter to purchase the rented property during or at the end of their rental period.
This option keeps the owner from offering the property to anyone else for rent or sale — essentially giving the current renter the first access.
After the term expires, the renter must either exercise their options or forfeit them.
2. How does a lease option work?
Compared to a standard, lease-purchase agreement, a lease option provides a potential buyer with increased flexibility.
When the renter/buyer and the owner enter into the lease option, they agree upon the price of the home upfront.
This price is normally the current market value of the home.
This is advantageous for the buyer because it allows them to purchase the home at the current price in the future.
As a result, the renter/buyer is typically charged a fee upfront by the owner.
Normally, this fee is around 1 percent of the home’s sale price.
However, this fee isn’t for nothing.
If the renter decides to purchase the home at the end of the lease the fee serves as a down payment.
3. When is a lease option optimal?
A lease option is great for those renters or buyers who may be working to build their credit or saving for a down payment.
4. What are the requirements for a lease option?
Here are some of the requirements associated with a lease option:
Rental payments
In addition to standard monthly rent, property owners typically charge a premium for renters to buy the property at the end of the leasing term.
This premium can be a percentage added to the current rent (i.e., 1 percent of the home’s sale price or 10 percent surcharge of the standard monthly rent).
This premium is often called “rent credit,” and it becomes part of the down payment for the home if the renter decides to buy.
However, the renter takes on a bit of a risk when they pay the fee because it’s non-refundable.
If they choose not to purchase the property at the end of the term, then they won’t get any of that money back.
Bank financing with a lease option
If you’re a renter/buyer, there are some bank financing options available.
In most circumstances, banks will permit the total funds of the premium to go to the down payment to purchase the home.
That said, if the rent was charged at an at-market rate, then they may not allow the funds to be applied to the purchase price.
We recommend checking with a few banks in advance to see what their policies are regarding financing a mortgage for a home with a lease option.
Lease option term
The lease term can be any length that the property owner and renter agree upon.
However, it is commonly between one to three years.
This contract also stipulates the purchase price of the property at the start of the lease — or, at the very least, how the price will be determined at the end of the lease.
5. Why should you use a lease option as a renter?
There are numerous reasons why people prefer to rent or buy depending on their circumstances.
When would you want to combine the two and use a lease option rather than purchasing a property outright?
As noted above, most renters use a lease option in the interim as they build up their credit or save up money for a down payment.
It’s also advantageous for renters who want to buy a property at today’s prices.
If the prices in the housing market are low, a renter may want to lock in the price now.
Once they’ve built up the money or the credit, they can take advantage of the price that they locked in with their contract.
Choosing a lease option takes the home off the market and allows the renter to live in it until they have enough money to purchase it.
Even buyers who have the ability (credit and funds) to purchase a property may choose not to.
They may not want to commit right away without knowing the neighborhood or if they haven’t been able to sell their old property first.
Furthermore, sometimes buyers have to make adjustments to a property before they are able to buy.
For instance, if they want to qualify for a VA loan, then they may need to make repairs or upgrades.
Using a lease option can give them the time to make these repairs before applying for and getting the loan.
6. Why should you use a lease option as an owner?
Lease options aren’t always preferable for property owners because utilizing this option means they lose the opportunity to sell the property for a higher price to other buyers.
That said, owners can charge more rent than they’d otherwise be able to with this option.
Some property owners use it if they had trouble selling the house outright, and they think the lease option will make the property more appealing to different types of buyers.
In other cases, a property owner will start using a lease option a few years before they want to sell the home.
This allows them to collect a premium above the current market for the rent.
If the buyer decides not to purchase the house (a worst-case scenario for the homeowner), then they’re simply able to place it on the market right after the lease term ends.
They also get to keep all the extra funds above the standard monthly rent.
Keep in mind that there can be tax complications that accompany selling the property outright now instead of later.
With a lease option, a homeowner will likely have a buyer ready to purchase their property at the end of the term (although it isn’t guaranteed).
7. Do you need renter’s insurance with a lease option?
Yes, renter’s insurance is normally required for the renter.
This type of insurance helps protect their personal belongings.
Be sure to check that the property owner also has homeowner’s insurance just in case something happens during the lease term that could impact the property’s value (i.e., fire or water damage).
8. What is an appraisal contingency, and do you need one with a lease option?
An appraisal contingency is a provision included in purchase contracts that allow buyers to back out of the contract if a home is appraised for less than the purchase price included in the contract.
At the end of the lease’s term, the home’s value could have decreased, and this contingency helps protect the buyer if there has been a drastic decline in the market.
Set up an appraisal that provides an updated property value before the purchase goes through.
9. What’s the difference between a lease purchase agreement and a lease option agreement?
The core difference between a lease option and a lease purchase agreement is that the buyer is not required to buy the home at the end of the rental period.
In a lease option, the buyer is able to purchase the home and has first access according to the contract.
However, it is not mandated.
They are able to walk away from the property entirely after their lease ends.
A lease purchase agreement, on the other hand, includes two documents, a residential lease and a contract for sale, both of which are signed at the beginning of the lease term.
As with a standard purchase and sale agreement, the contract for sale obligates the buyer to purchase the property by a certain date.
10. What questions should you ask?
If you’re presented with a lease with the option to buy, should you take it?
What else do you need to know?
It can be an overwhelming proposition if you don’t know anything about it.
Here are a handful of questions we recommend you ask, so you have all the information you need.
“How is the deal structured?”
Understanding the terms of the deal is essential before moving forward.
You need to know the following:
- The length of the agreement
- The amount of the option fee
We recommend seeking the counsel of a real estate attorney who has experience with these agreements.
Ask them to look over any contracts before you sign.
“What’s my plan to prepare for the purchase?”
When you go the lease option route, you’re anticipating your ability to qualify for a mortgage so you can purchase the property.
However, you have to make sure you have a path to do that.
Talk to a lender in advance to ensure they can credit the money you’ve paid to the homeowner on top of your rent payments toward your purchase.
While you save up your down payment, use your time renting to improve your credit so you can qualify for the best rate possible.
You can improve your credit by paying down your debt, avoiding opening new credit accounts, and paying all of your bills on time.
“How is the housing market in my area?”
Depending on the market in your area, you may want to lock in a price at the start of your contract or make the sales price contingent on an appraisal at the time of sale.
Home values will likely fluctuate at least a little bit (especially if you have a longer lease period).
Determine what will be most advantageous for you and see if you’re able to get the homeowner to agree to it.
“Who’s responsible for what?”
Make sure your contract determines who is responsible for maintenance and repairs of the home before the end of the term as well as homeowners’ association fees and utilities.
“Do I need a home inspection?”
In all likelihood, yes.
Investing a few hundred dollars upfront on a home inspection can save you a lot of trouble.
It can verify that your potential home doesn’t have any major flags, or if it does, then when and who they’ll be repaired by.
“Have I considered other options?”
A lease option is a great solution for a lot of homebuyers, but it’s not quite right for everyone.
Don’t jump into a contract just because you’re desperate to buy a home.
Take a step back and ask yourself, “Is this the right path for me? Have I considered all my options?”
In the end, you want to make sure that you’ll be able to purchase the rental home at the end of the lease period.
Otherwise, you might be better served with a standard rental agreement.
Additionally, you really want to spend the time in the contract period working on your finances.
You should be saving up your cash for a down payment and improving your credit, so everything is in order for that final transaction.
Sometimes tenants/buyers forget that they’re spending extra cash on the lease option’s above-market rent, so if you go this route, you should make meaningful progress toward homeownership.
11. What should you consider before moving forward?
Lease options can become complex because you’re dealing with two different types of relationships.
In some situations, you’ll serve as tenant or landlord.
In other situations, you’ll serve as buyer or seller.
The role a landlord plays is much different than that of a seller.
If you are the seller/landlord, here’s what you should consider:
The structure of a lease option should not resemble a contract for a deed.
The lease option should be between one to three years depending on what works for both parties.
The landlord must hold a security deposit.
The landlord/seller should continue to pay property taxes and insurance.
The landlord/seller should avoid giving large rent credits to the tenant/buyer.
Refrain from using the words “credit,” “seller,” and “buyer” in the lease agreement or the option agreement portion of the Lease Option.
Lay out whether the tenant/buyer will be able to make improvements during their lease term and what the value of those improvements will be.
Determine the difference between the tenant/buyer’s option price and the fair market value of the property. When the prices are closer, one can claim they are more equitable.
Final Thoughts
A lease option can be the perfect route if you’re working toward homeownership but you’re not quite there.
Take your time deciding whether this option makes sense and then have a real estate attorney look over the paperwork on your behalf.
They can walk through the agreement with you and answer any questions to ensure you’re getting yourself into a good situation for the next few years while you get your finances in order to become a homeowner!
Additional Resources
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Disclaimer: we are not lawyers, accountants, or financial advisors and the information in this article is for informational purposes only. This article is based on our research and experience and we do our best to keep it accurate and up-to-date, but it may contain errors. Please be sure to consult a legal or financial professional before making any investment decisions.
Prior to starting Gokce Capital, Erika received a Bachelor of Architecture from the University of Southern California and a graduate degree in Urban Policy from Columbia University. She worked as both an architectural designer and engineer in New York before joining the New York City Department of Housing Preservation and Development.
Erika currently lives in the New York Metropolitan area with her spouse, daughter and cat. She is originally from Chicago and still considers herself a midwesterner at heart.
Erika also loves to read, write and travel (fun fact, she has visited all 50 states and more than 30 countries!). Her new book, Land Investing Mistakes: 11 True Stories You Need To Know Before Buying Land, is now available on Amazon.