What is a lease option and how does it work?

Have you recently considered buying a house but aren't sure you're ready to commit? Maybe you don’t have enough saved for a down payment, or you need more time to improve your credit before applying for a mortgage.

One solution is to rent or lease a home before buying it, which you can do with a lease option agreement. Learn more about an option to purchase lease agreement, how it works, and when it makes sense to sign one.

What is a lease option?

A lease option is a clause in a rental agreement that allows the tenant to buy the property at the end of the lease.

The homeowner and the tenant are free to work out the details and lease terms, including the lease term, the purchase price, and the date the tenant must exercise the option to buy.

An option to purchase lease agreement usually requires the tenant to pay an option fee. The agreement also determines how much of the tenant’s monthly rent may be credited toward the purchase of the home.

A lease option gives the renter flexibility. If they like the home, they can buy it when the lease is up or forfeit the option fee and move on.

The property owner earns rent and sets up a potential sale. If the tenant declines to buy the home, they keep the option fee as compensation.

What’s the difference between a lease option and a lease purchase?

A lease-to-purchase clause in a real estate contract requires the tenant to buy the home from the landlord at the end of the lease. A lease option allows the tenant to decide whether to buy the home at the end of the agreement. The difference is that at the end of a lease purchase agreement, both parties have already agreed to a sale.

What’s included in a lease option?

A lease option contract is a regular rental agreement with a few extra clauses. A lease option typically includes:

• A finite lease term. This is how long the tenant agrees to rent the property before they can buy it.
• The purchase price. A lease option deal should include the price the tenant will pay the owner if they choose to buy the home.
• Option fee. The up-front fee the tenant pays the owner is usually 1% to 5% of the agreed-upon purchase price.
• Monthly rent. The deal will include the monthly rental amount and who's responsible for utility bills.
• Rent credit. This specifies how much of the rent is credited toward a down payment on the home.
• Commitment to purchase. A lease option should clarify that the homeowner is committed to allowing the renter to buy the property at the end of the lease.

Lease with option to buy: How it works

If you're deciding between renting vs. buying, it’s important to understand how a lease option works. That way, you can avoid surprises. Here’s the basic process:

1. Negotiate and sign a contract

You and the owner negotiate and sign a rental contract with a lease option clause. Make sure it includes the date and price at which you can purchase the property, and carefully review any limits or exceptions. Potential red flags include vague language and unreasonable concessions, such as refusing to allow a property inspection. Finally, it's always a good idea to have a real estate attorney review a contract before signing.

2. Pay the option fee

Once you sign the contract, you'll pay the agreed-upon option fee and any required security deposit. The option fee is usually credited toward the home's purchase price, not the down payment. Make sure the terms are fully and clearly explained in the contract.

3. Pay rent

You’ll move in and start paying rent. Part of your payment may be credited to a down payment on the home, so you may pay more per month than the average rent in the area.

4. Decide whether to buy

When the lease expires, you can buy the home or walk away. If you buy, you get a mortgage and close on the sale. If you walk, you probably forfeit the option fee and any money you paid toward the down payment, but you won’t get stuck with a house that’s not right for you. The owner keeps the option fee and the house.

When does a lease option make sense?

A lease option can be a good deal for buyers and sellers.

For buyers

The obvious benefit of a lease option is that you can live in a home before buying it. Other benefits include:

• Locked-in purchase price. If you buy the house, you'll pay the price you and the landlord agreed on at the start of the lease. You'll pay the negotiated price, even if the property's value has increased.
• No bidding wars. Nobody else can buy the home while the lease is in effect, which means you won’t have to compete with other buyers.
• Time to plan. You have time to improve your credit score and save for expenses like the down payment and closing costs. This can help you get approved for a mortgage with better terms by the time the lease is up.

For sellers

Benefits of a lease option for sellers include:

• Rental income. If you are going to sell the house anyway, a lease option lets you earn rental income while you wait. If the tenant decides not to buy, you'll keep the option fee and any down payment money paid.
• It could help a property sell. Sometimes a property is challenging to sell. A lease option gives potential buyers a chance to live in the home and discover its charms before deciding to buy.
• Combines the benefits of selling and holding real estate. You might lose a sale, but you won’t lose the house. You can instead hold it in your real estate portfolio.

When does a lease option not make sense?

Even if a lease option sounds like a great idea, it doesn’t make sense in every situation.

For buyers

As a buyer, you may be better off without a lease option if:

• You won’t qualify for a mortgage when the lease is up. This can lead to heartbreak, so if you’re going into a lease option agreement, you’ll want to make sure your finances are in order. While you don’t have to get approved for a mortgage right away, learn what's required to qualify for a mortgage now so you’re prepared.
• You struggle to see yourself living in the home long-term. In this case, paying the extra fees to secure a lease option may not be the best use of your money.

For sellers

Potential drawbacks of lease options for sellers include:

• Risk of the tenant not following through with the purchase. You’d have to start the sale process from scratch, which will take time.
• Selling below market value. Even if your home has increased in value, a lease option requires you to sell it to the tenant for the price you agreed to. You may miss out on selling your home for more money as a result.

FAQ

Here are answers to common questions about lease options.

Who should draft a lease-option contract?

A lot of money may be on the line, so you’ll want an expert to write your lease option contract. A real estate attorney is the best option.

Where can I find homes with a rent-to-own option?

A real estate agent can help you find lease-option homes in your area. You can also ask a homeowner directly if you’re really interested in buying their property but want to live in it first. It never hurts to ask.

Can I get out of a lease option agreement?

Yes. A lease option agreement differs from a lease purchase agreement because you can choose not to buy the property at the end of the lease. If you do this, you'll lose your option fee and any money you put toward the down payment. If you want to get out of a lease option agreement before the lease is up, you can ask your landlord to release you or review your contract to see if there are any penalties for terminating the agreement early.

The bottom line: A lease option offers a step toward homeownership

Ultimately, a lease option can be a helpful step toward homeownership for buyers who need more time to save, build credit, or test out a property before committing. It also offers sellers a way to earn rental income and secure a potential buyer while holding onto their asset. Use the rent vs. buy calculator from Rocket Mortgage to help you evaluate your options.

Ready to take the next step toward owning a home? Start a loan application today with Rocket Mortgage to see what you qualify for.