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There are many possible paths to becoming a homeowner. In some cases, especially if you’re a first-time home buyer, you might consider a “rent to own” program, often referred to as a lease purchase agreement.
Depending on your current financial and personal situation, a lease purchase agreement might help you eventually buy a home that would otherwise be out of reach. These agreements are popular because they allow you to “test drive” your home without needing to make an immediate, long-term commitment.
Of course, as is the case with any long-term homeownership contract, lease purchase agreements will have drawbacks. Before signing a lease purchase agreement, it will be critical to ensure you understand exactly what you’re agreeing to.
What Is a Lease Purchase Agreement?
Sometimes referred to as a lease purchase contract, a lease purchase agreement is a specific type of rental contract that allows people who are renting a property from a landlord to eventually become the owner.
Lease purchase agreements offer an alternative path to homeownership, making it possible to someday become a homeowner without needing to make a full down payment right away. If there’s a property currently offered as a rental, a lease purchase agreement can be used to eventually trigger full homeownership.
How Do Lease Purchase Agreements Work?
With a lease purchase agreement, a renter agrees to pay a landlord an upfront fee and extra toward the monthly rent payment. The extra payment is set aside to act as a down payment toward the future purchase of the home. For a lease purchase agreement to work, both parties need to agree to a few basic terms.
The landlord must be willing to sell
The current owner of the property (the landlord) will need to be willing to sell the property once the leasing period has expired – if they’re not interested in selling, then initiating a lease purchase agreement will simply not be possible.
The renter intends to buy
The renter should have the intention to purchase the property at the end of the term. If the renter declines to exercise their lease purchase right, the landlord then has the right to either continue renting the property (to either the original renter or a new one) or sell the property to another buyer.
The landlord and renter agree to purchase terms in advance
The parties will also need to agree upon the terms before the purchase. This requires negotiating the length of the lease (often 1 – 2 years), as well as the eventual selling price of the home. When property markets are exceptionally volatile, negotiating a future selling price will often be more difficult.
If the renter does decide to purchase the property at the end of the lease term, they will then have the exclusive right to do so – this means other parties, regardless of what they’re offering, will not be able to outbid them for the property.
Renter must be able to secure financing
For the current renter (future buyer) to take ownership of the home, they will need to secure financing once the lease has expired. With most lease purchase agreements, failure to secure a mortgage will nullify the terms of the initial contract.
How Can You Structure a Lease Purchase Agreement?
While most lease purchase agreements follow the same general structure, it’s important to carefully review any lease purchase agreement you’re considering and ensure you know exactly what you’re getting into. Some common questions to consider are:
What is the length of the lease period?
This will describe the amount of time you can live in your home before deciding whether or not to exercise your right to buy. The typical lease period is 1 – 2 years.
How much of each month’s rent will contribute to the future down payment?
If you plan to buy the home at the end of the lease period, you’ll need to set aside enough money to cover at least a portion of the down payment. Even mortgage programs like Federal Housing Administration (FHA) loans require a down payment of 3.5%. So be sure to set aside enough money from each monthly payment to cover the down payment before the end of your leasing period.
What upfront fee will the renter be paying?
The renter usually pays a nonrefundable fee to the landlord as a condition of agreeing to a lease purchase agreement. This fee can be negotiated, but it often falls between 1% – 5% of the home’s purchase price. This is similar to a security deposit or the earnest money you pay when you make an offer on a home. However, you may not get it back if the sale falls through.
Who is responsible for taxes, insurance and other financial aspects?
Assuming the property is still in the landlord’s name, they’re usually responsible for covering the costs of property taxes and homeowners insurance. They’re also responsible for making the necessary payments into escrow or to their insurer and local tax authority to cover these costs. If the landlord wants the renter to cover these costs or take responsibility for these payments, they will need to agree in advance.
Also, if there are home repair and maintenance costs during the lease period, the renter and landlord will need to decide in advance how these costs should be covered.
What will the future sale price of the home be?
In most cases, this value will be determined by the current fair market value (FMV) plus an additional premium to account for future appreciation. Lease purchase agreements with a relatively longer term (such as 3 years instead of 1 year) will typically include a higher premium to account for additional appreciation and uncertainty.
Ultimately, the lease purchase agreement should clearly answer any questions you might have. If you’re unable to know what you’ll be paying, what your rights and responsibilities are or any other detail, then the purchase agreement might need to be amended.
Generally, it’s a good idea to work with an experienced real estate attorney who can help you identify red flags and answer questions.
What Is a Lease Purchase Agreement vs. a Lease Option Agreement?
A lease purchase agreement and a lease option agreement describe similar concepts, but there are a few important differences between these types of contracts. A lease purchase agreement creates a legal commitment for both parties to initiate a transaction once the term has expired. While it is possible to get out of a lease purchase agreement, doing so can be costly. A lease option agreement, on the other hand, represents a softer commitment.
What Are the Pros and Cons of Lease Purchase Agreements?
As you’d probably expect, a lease purchase agreement presents benefits and drawbacks for both buyers and sellers. Be sure to consider the pros and cons before deciding to enter into an agreement.
PROS of Lease Purchase Agreements👍
One of the most obvious benefits of a lease purchase agreement is that it gives buyers more time in the home before fully committing to becoming a homeowner.
By agreeing to a sale price in advance, the renter may get a good deal on a home if prices are set to increase in the near future. If prices drop, the landlord may make a larger profit from the sale.
By having a few years to prepare for the homeownership process, prospective buyers can improve their credit score, save up for a down payment and build savings that can later be used for other aspects of homeownership.
Before the lease ends, the buyer can potentially build future equity they can access once the home is in their possession.
Landlords and renters can benefit from sharing maintenance expenses, especially if the home is a fixer-upper. By using a lease purchase agreement, both the landlord and renter can also save on listing fees and other home buying costs.
CONS of Lease Purchase Agreements👎
If the tenant chooses not to exercise their option (or is unable to secure a mortgage), all money that has been going toward their down payment is forfeited. If they’ve been living at the property for an extensive period of time, this can potentially cost them several thousand dollars.
Additionally, it’s important to note the option fee is nonrefundable. In the end, if someone has a lease purchase agreement they don’t end up using, they’ll likely be financially worse off than if they had simply rented all along.
A lease purchase agreement can help renters with lower credit make the transition to homeownership. But if they aren’t able to qualify for a mortgage loan, they may be left having paid more for a rental than they should have.
A Test Drive For Your Home!
A lease purchase agreement is a lot like leasing a car – it allows you to test out a major investment before making a full commitment. However, in most cases, you should only use a lease purchase agreement if you’re seriously considering becoming a homeowner. Otherwise, you’ll end up overpaying for rent.