Lease Purchase Agreement: What It Is And How It Works
Buying a home is a significant financial undertaking. As a result, some potential home buyers need to ease into homeownership instead of diving right in. A lease purchase agreement or a rent-to-own contract lets a potential buyer rent a property with the intent to purchase it when the lease period is up. In addition, a lease to purchase agreement can help buyers who are struggling to qualify for a mortgage or need a little bit more time to beef up their down payment.
With this in mind, let’s explore the purpose of this legally binding rental agreement and what’s at risk, as well as the benefits of entering into one.
What Is A Lease Purchase Agreement?
A lease purchase agreement, also called a rent-to-own agreement, is a contract between a renter and a landlord. This agreement allows a renter to lease a property for a period of time before purchasing when the lease agreement expires. The renter typically pays an option fee for the right to buy the property later.
In the lease purchase agreement, both parties agree to what the purchase price will be and the length of the lease term. The contract will also outline the percentage of the rent that will go toward the renter’s down payment. Typically, landlords charge rent above market value so that a portion of the monthly rent can aid the renter’s down payment when purchasing the property later on.
In addition to agreeing to buy the property, the renter must qualify for a mortgage at the end of the lease term. Unfortunately, they lose the right to buy the property if they cannot receive mortgage approval from a lender.
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Lease Purchase Agreement Vs. Lease Option
While a lease purchase agreement and lease option agreement seem the same, this is not the case. Both agreements are similar in that they include a lease contract and an option fee and disallow the owner from selling the home to anyone else during the lease period. But the critical difference between the two is the purchase portion of each agreement.
With a lease purchase agreement, the buyer is expected to buy the property once the lease expires. In other words, the sale of the property is set in stone unless either party breaches the terms of the contract. At the same time, a lease option agreement gives the buyer the option to purchase the property at the end of the lease period, but they are not legally obligated to do so.
Who Might Benefit From A Lease Purchase Agreement?
A lease purchase agreement may be suitable for those looking to become homeowners soon but don’t have their finances ready to buy a house immediately. Some other situations that make sense for a lease agreement include:
- The buyer’s credit score and debt-to-income ratio don’t meet the lending requirement to qualify for a mortgage.
- The buyer doesn’t qualify for first-time home buyer assistance programs.
- A buyer is unsure if they are ready to purchase a property due to the volatility of the housing market or other uncertainties like a potential job transfer.
- The seller is facing pre-foreclosure.
- The seller is struggling to sell the property due to factors like a buyer’s market.
- A seller wants to capitalize on a rental income stream and offload the property later.
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How To Structure A Lease To Purchase Agreement
A lease purchase agreement is usually two contracts combined: a lease agreement and a contract of sale. The lease agreement potion outlines the lease terms and conditions, whereas the contract of sale outlines the sale terms once the lease expires.
Here are some of the components and terms you can expect to find in both.
1. Lease Period Length
Like with standard lease agreements, the first order of business is to determine the lease length and rent price. Therefore, the buyer and owner must identify a term length that benefits both parties.
For example, if the buyer needs time to increase their credit score or lower their debt-to-income (DTI) ratio, a longer agreement may be beneficial. Typically, lease agreements should not surpass 3 years.
2. Purchase Price Determination
The contract of sale is the portion of the agreement that outlines the terms and purchase price of the home after the lease expires. While the purchase price is usually higher than fair market value to account for the appreciation of the property, both the buyer and owner must agree on a price they are comfortable with. Therefore, even if the market fluctuates, the purchase price in the contract will not vary.
The buyer and seller will also agree on an option fee, which gives the renter the right to buy the home at the end of the lease. The option is usually nonrefundable. So, if the renter breaks the contract, the seller can pocket the option fee.
3. Security Deposit
A security deposit is a sum of money the buyer pays before moving into the rental property. This sum could be used to pay for repairs if the tenant damaged the property during their lease agreement. The security deposit guarantees that if the lease agreement falls through, the owner will have the cash to pay for repairs if the tenant damages the property beyond the typical wear and tear of renting.
4. Taxes And Insurance Responsibility
The individual responsible for paying maintenance fees, homeowners insurance and property taxes should be detailed in a lease purchase agreement. Typically, the tenant is responsible for these payments.
5. Rent Credit Details
Sellers may include a clause in the lease agreement that allows a percentage of monthly rent payments to go toward building equity in the home. For this clause to apply, a specific percentage of rent must be outlined in the agreement.
6. Maintenance Responsibilities
The tenant is typically responsible for home maintenance expenses such as repairs. Buyers and owners usually consider this a fair arrangement since the buyer will eventually own the property. But, the specifications of the financial responsibilities of home repairs should be outlined in the lease agreement.
7. Miscellaneous Terms
The lease to purchase agreement and the contract of sale usually include cross-default provisions, making specific clauses mutually exclusive. So, if either party violates a provision in the lease agreement, like defaulting on rent payments, it can automatically void the contract of sale.
Additionally, the buyer must qualify for financing by the end of the lease term. If they cannot qualify for a mortgage, they may forfeit the sale portion of the contract.
Benefits Of Lease Purchase Agreements
Buyers and owners can both benefit from a lease purchase agreement. However, like with any contract, there is a level of risk each party should be aware of.
Owner Benefits
Owners can benefit from a rent-to-own agreement in the following ways:
- Easier selling process: Selling a home through a REALTOR® or estate agent can often be lengthy and tedious. Choosing a lease purchase agreement can simplify the process since the seller can transfer ownership on the closing date.
- Locks in the property’s sales price: The owner can lock in the home’s purchase price upon completing the lease purchase agreement. Depending on the market conditions, this could be a favorable option to the seller, specifically if the real estate market is cooling off.
- Attracts tenants: For property owners struggling to find tenants, a rent-to-own agreement may attract responsible renters and take good care of the property.
- Large upfront option fee: Even if the buyer is unable to move forward with the transaction and defaults, the seller has the right to pocket the option fee when the lease expires.
- Help with maintenance costs: As part of the lease purchase agreement, owners can require renters to split some of the maintenance, property taxes and insurance. Having the renter pay a portion of the housing expenses can offset the owner’s cost.
Buyer Benefits
First-time homebuyers and renters may find a lease to buy agreement appealing for a variety of reasons including:
- Rent turns into a down payment: A portion of the buyer’s rent can go toward the down payment, which can help the buyer save for a more substantial down payment. However, in some cases, the rent payment will exceed the market value, so the landlord isn’t losing money on the property.
- Builds equity in the home: When the home’s value exceeds the already prearranged purchase price, the buyer instantly builds equity in the home.
- Avoid moving again: Moving is not only stressful, but it’s costly. The buyer can stay put and avoid moving costs with a rent-to-own agreement.
- Time to repair credit score, DTI ratio, etc.: For the buyer that doesn’t have a favorable credit score or DTI, renting to own can give them time to improve their financial standing. This way, the renter can save interest money and lock in better loan terms.
- Provides a test drive of the home: Rent-to-own agreements give buyers time to test a property before deciding to buy. So, if they are unsure of where they want to live, they don’t have to decide immediately.
The Bottom Line
A lease purchase agreement is a contract between a renter and owner that gives the renter the right to buy the home after the lease is up. The agreement is advantageous because it gives a renter more time to prepare financially for buying a home.
But, remember, how you buy a home depends on your unique financial situation and what works best for your needs. Therefore, exploring all options before entering a lease-to-purchase agreement is wise.
