If you're shopping for a home but are not quite ready for a traditional mortgage, a lease purchase agreement may be an alternative to explore. This type of financing, sometimes called rent to own or rent with the option to buy, functions much like a traditional lease while subtly preparing you for home ownership.
How it Works
When you purchase a home using a lease purchase agreement, you start by paying an option fee on the property. This fee, typically 1 or 2 percent of the purchase price, secures your right to purchase the property at the end of the lease. In addition to the option fee, your seller may require additional up-front payments -- including down payments and security deposits -- as well as the first month's rent. You will continue to make regular rent payments for the duration of the lease term, during which the seller may apply some portion of each payment to the purchase price. At the end of the lease, you can purchase the home using a traditional mortgage, cash or any other financing option available to you.
Benefits of a Lease Purchase
Lease purchase agreements are useful if you have little or no money set aside for a down payment. They also allow you some time to improve your credit score before applying for a traditional mortgage. When you purchase a home using a lease purchase, you typically lock in the sale price at the start of the lease. This agreement can be beneficial if the property value rises during the lease. Sellers also benefit from lease purchases by reaching a larger group of prospective buyers, including those who may not qualify for a traditional mortgage.
Drawbacks for Buyers
In most lease purchase agreements, the option fee you pay is non-refundable. If you are unable to purchase the home for any reason, including being unable to qualify for a mortgage at the end of the lease, you likely will lose the money you paid up front. Some lease purchase agreements also contain due-on-sale clauses that specify additional expenses at the end of the lease. These expenses might include typical closing costs like home inspections and document fees, but also may include other expenses that the seller specifies. In addition, your real estate attorney can check for any outstanding mortgage liens, tax liens or other outstanding debts that may prevent a successful sale at the end of the lease.
Considerations for Sellers
During the lease term, the property functions like a rental. You may be responsible for repairs, upkeep, taxes and other responsibilities associated with rental property. If the value of the property increases significantly during the lease term, you may miss out on additional gains. If the buyer is unable to qualify for financing at the end of the lease, you may also find yourself relisting the home and finding another buyer.