What's The Difference Between a Lease-Option and a Lease-Purchase?
Throughout my guide, I interchangeably use the terms lease-option, and lease-purchase, which are very similar by definition, but slightly different.
A lease-option is a property lease with an added option to buy it, which the tenant (called the 'optionee') is not obligated to exercise. Only if he or she chooses to exercise the option to purchase the property is a sales contract initiated. A lease-purchase, on the other hand, is already a purchase. It's drafted on a purchase and sales agreement and is merely awaiting the fulfillment of a term or condition before it culminates in a closing (the date of which is predetermined).
If, for example, a prospective buyer, who doesn't have all of the funds needed for a down payment to purchase the home, asks the seller if they'd accept a lease-purchase arrangement. The contract would set a future closing date, as well as spell out all other terms of the deal, such as financial arrangements and the payment of closing costs. If agreed upon, the buyer typically takes possession of the property, subject to the terms and conditions of the occupancy.
These two terms are similar, but they are not the same because a lease-option is more flexible, whereas with a lease-puchase the terms are all set in advance, a purchase and sale agreement is actually signed around (sometimes at Escrow) TIP, and non-refundable Option money is put down at the commencement of the lease. A lease-purchase is a better way to go if your goal is truely to sell your property. If you are an investor, with a portfolio of properties, whose long term goal is to hold real estate, but like the idea of renting for a higher monthly premium, with tenants who generally take better care of your home than they would a staight rental, then a lease-option would be good for you.
Throughout this guide, I intermix the two terms lease-option and lease-purchase for the sake of flow, however, I am referring to a lease-purchase in most instances. Do keep in mind however, that you can apply all of the same principles and still offer only a lease-option (I can personally help you with this) TIP CT.
How Does a Lease-Purchase Work?
In a nutshell, a lease ageement and a purchase and sale agreement are both signed up front, at the commencement of the lease. The optionee pays an option consideration of up to 5% TIP FA, typically, but the seller can charge more or less depending on the situation. That's the great thing about lease-options - they afford flexibility. In addition to the option consideration, the optionee pays 1st month's rent before taking possession.
A portion of the monthly rent applies toward the the optionee's purchase (the rent credit) FA. For example, if a house rents for $2,000 per month with a $400 per month rent credit. At the end of 12 months, the optionee will have built a $4,800 which can either be held in Escrow, so that the funds may be used toward the optionee's down payment when they buy, OR the rent credits can simply buy down the purchase price TIP.
The purchase price is locked in at 3-5% over the current market value, per annum. Just like any other credit based program, when one has less than perfect credit the corresponding interest rate or premium will be higher.
What Are the Benefits of a Lease-Option for a Seller?
· Sales Price At the Top of the Range: Renters are willing to pay a premium to get on the path to home ownership, which allows them time to raise a larger down payment or improve their current financial situation. Because of strong buyer demand for lease-options, home sellers can charge top dollar for their properties.
· Above Market Rent: Because the seller is accommodating the optionees inability to purchase conventionally, they can demand a higher than fair market rent. Many prospective home buyers can usually afford the monthly payment but they often have insufficient cash for a traditional loan's down payment.
· Substantial Option Consideration From The Optionee: Which incentivizes them to make timely payments, and take care of the property. In the event they should default, the seller keeps the option consideration, as it's non-refundable under all circumstances.
· Faster Market Time: In general, the lease-option technique is one of the quickest and least expensive methods available to those selling real estate. Both renters and those in the market to purchase a home can benefit from a lease-option so you are drawing the interest of a much larger market. No matter how slow the local
real estate market might be, there is almost always good demand from lease-option buyers. A higher demand results in a quicker market time, in most instances. Now, more than ever before, lease-options are in high demand.
· Low Agent Commissions: Save 6-7% with no agents involved, or up to 4% with just one agent involved TIP!
· Attraction of the Highest Quality Tenants: Because you are marketing your home toward people looking for a chance to own real estate, once they entered into a lease-option agreement they have a vested interest in the said property. They think like homeowners, and tend to take great care of the property for fear of defaulting and losing what they've invested (such as the Option Consideration, the higher than fair market rent, and in some cases monies spent to improve the property). Additionally, many of the people who are looking to enter into a lease-option to buy a home, have already applied with a mortgage consultant and were denied due to credit, or lack of down payment. These people are already well on their way to being able to qualify to purchase, so their lease terms are typically shorter, and the quality of the tenant is much higher.
· Less Maintenance: The optionee is responsible for all maintenance, repairs and upkeep, so the seller plays a 'hands-off' Landlord role. Per my lease-purchase agreement, optionees understand this and because they have a vested interest they act like a homeowner and typically have a sense of "pride in ownership" that encourages them to pay on time, perform maintenance, and make improvements to your home. Often, your home is in better shape at the end of the optionee's lease than it was to begin with. If the optionee does not exercise their option to purchase, your home may be worth more.
· On Time Payments: The way my program is set up, the optionee's rent credit is forfeited if rent is recieved after the 5th of the month (see my lease-option contract, paragraph 28d). Additionally, I recommend that sellers set up an automatic payment plan so that the optionee's bank account is debited each month on a certain day (typically the 1st, but a different date can certainly be agreed up between the seller and optionee). The funds can be electronically transferred into your bank account, or depending on the 3rd party rent collection company you use, you can have a cashier's check mailed to you HT.
· Tax Benefits: Because the seller remains on title (retains ownership) until the option is exercised, they maintain all of the tax deductions as the property owner.
As a landlord, the property owner can also depreciate the property as well as retain the property tax and mortgage interest tax deductions. As a result, not only is the Seller's loan payment sheltered from income tax, a "paper" loss is created that can be used to shield ordinary income from income tax as well.
The landlord may also be able to defer having to pay tax on the rent credit as long as it's termed, 'Option Consideration', meaning that you must specify in your agreement (which mine does, in paragraph 28d) that the tenants monthly rent credits apply toward their option consideration. Please see an accountant specializing in real estate to find out if you can defer paying tax on that amount under Section 1234 of the Internal Revenue Code.
If the seller has personally lived in the said property, as long as they don't lease-option the home for more than 3 of the last 5 years, they can probably qualify for the capital gains tax exemption. Please see an accountant specializing in real estate to find out if you can qualify under the Taxpayer Relief Act of 1997. This act exempts from taxation profits on the sale of a personal residence of up to $500,000 for married couples filing jointly and $250,000 for singles,if you purchased it after May 6th, 1997, and if you (and your spouse if that applies) lived in the property for at least two of the previous 5 years.
· Easier For Tenant to Get Home Loan: Recorded Lease-Purchases***, over 12 months in length, make the qualification process for a mortgage easier for the enant, and make a large loan with a lower down payment possible. This will help you close the transaction at a higher price.
What Are the Benefits of a Lease-Option for a Renter?
· Easier to Get Approved: The purchaser is not required to conform to the various underwriting guidelines that banks and other lenders require. The seller, unlike an underwriter working for a mortgage company, requires little in the way of documentation. The seller providing the financing really doesn't care where the money for a down payment comes from...after all, cash is cash.
· Small Amount of Up-Front Cash Required (compared to the amount that would be needed for a down payment to purchase a home outright): The amount of up-front cash needed to acquire a home or other property on a lease-option is usually small; often just a few thousand dollars for the first month's rent plus non-refundable option consideration TIP. This option money is in lieu of a security deposit.
· Monthly Rent Credit Builds a Down Payment: The unique characteristic of a lease-option is the rent credit toward the buyer's down payment. Typically, the rent credit is 10 to 100 percent of the monthly rent, depending on how motivated the seller is to sell. The higher the rent credit percentage, the greater the probability the tenant will buy ST.
·Time to Improve or Build Credit: A Lease-Option affords a tenant time to repair less-than-stellar credit before they purchase. Even if one has decent credit to start, it can be beneficial to do a lease-purchase rather than buy outright as a credit improvement of say, 50 points for instance, can receive a better interest rate on a mortgage loan. Just .5% less of an interest rate can save a buyer tens of thousands of dollars over the course of the loan term. All the while the optionee is leasing, they can potentially be building equity in the ome they have the option to buy.
· Monthly Rent Credits: Buy down the loan amount or apply toward their down payment.
· Financing Is Easier to Obtain: There are loan programs available which will make qualifying easier for an optionee. Additionally, some lenders will qualify an optionee for a REFINANCE rather than a typical home loan, meaning their option consideration, rent credits, and any equity can apply toward their down payment.
Many lenders require that a memorandum of the lease-option agreement be recorded with the County in order for the optionee to qualify for special types of financing geared toward lease-options.
PLEASE NOTE: The optionee's names are not recorded on title, and they are not entitled to any equity or ownership. The Lease is simply mentioned on title so that lender requirements are met.
The first thing that you have to be on the look out for is whether or not the seller is even interested in selling. Some owners are simply looking to make money off of you in a very smart way. They will simply try and get you to pay the option fee and rent out the property for a 12 month period. After which they will do the exact same thing to someone else. In this way, they will always be getting a form of regular income in the form of rent and additional money up front in the form of the option fee. They will prevent you from buying the home even if your credit has been repaired by pricing it so high that it will not appraise. You need to be very careful about this as it is quite common.
Many look to lease out a property with the aim of getting their credit score up so that they can buy out a home on a mortgage themselves. What you have to realize is that most leases only last for a 12 month period which is not adequate enough for one to repair their credit score. You need to be looking for at least a 24 month term if you are to have any hope what so ever of repairing your credit score.
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