Lease Option: Definition And How It Works
Deciding if it makes more sense to rent or buy a home can be understandably overwhelming for many. Buying a house is a big commitment that can come with numerous advantages, but saving for a down payment while also keeping up with your monthly living expenses can make the dream of homeownership seem out of reach.
However, there is another option that can offer some additional flexibility as you decide whether you should buy or rent: a lease option. Let’s go over what a lease option is, how it works and the factors to consider when deciding if it’s the right move for you.
What Is A Lease Option?
A lease option, also known as a lease with option to buy, is a type of rent-to-own real estate contract that gives a property’s renter the opportunity to buy the property once the lease term is up. As part of the contract, the renter pays an option fee upfront for the chance to buy the property, as well as an additional fee each month that goes toward the down payment should the renter decide to exercise the option to buy.
A lease option also prohibits the property’s owner from selling it to anyone other than the tenant during the term of the lease. Should the renter forfeit the option to buy at the end of the lease term, they lose the option fee and any money that was put toward a down payment.
Lease Option Vs. Lease Purchase Agreement
Another type of real estate contract that’s worth differentiating a lease option from is a lease purchase agreement. With this type of contract, both the buyer and the seller are committed to the sale of the property at the end of the lease term. In the case of a lease option, the renter is under no obligation to follow through with buying the property.
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What’s Required For A Lease Option?
A lease option should include several key pieces of information in the contract:
- Lease term: A lease option agreement should specify the length of time during which the renter will occupy the property before they can purchase it.
- Option fee: In exchange for the chance to buy the property, the renter will pay the property’s owner an option fee, which should be included in the contract.
- Purchase price: Regardless of whether the renter ultimately buys the property, the purchase price will need to be stated in the lease option agreement.
- Rental amount: The renter and property owner will also need to agree on the monthly rent amount.
- Rent credit: The contract should specify how much, if any, of your monthly rent is to be credited back toward your eventual down payment on the home.
- Mandated homeowners insurance: While not required, it’s a good idea for renters to ensure that the property owner maintains homeowners insurance on the property throughout the lease term in the event that something happens to negatively affect the property’s value.
Lease With Option To Buy: How It Works
Let’s take a closer look at how lease options work, step-by-step.
1. Sign a contract. A lease option begins when a tenant and landlord or real estate investor enter into an agreement. Both parties need to agree on important aspects of the contract, including the length of the lease and the sales price of the home, which is typically the property’s market value at the time the lease is signed.
2. Pay the option fee. Once the renter (now the potential buyer) signs the contract, they will need to pay the option fee, which typically ranges from 2% – 7% of the total purchase price.
3. Pay rent. Throughout the lease, the renter typically pays above-market rent to live in the property. Their payments will include an additional monthly premium (sometimes called a rental credit), which will be put toward their down payment should they choose to move forward with the purchase at the end of the lease.
4. Choose whether to buy or forfeit. When the term of the lease is up, the renter has the option to proceed with buying the property or to walk away. If they choose the latter, they forfeit the money that was put toward the option fee as well as the additional monthly payments, but beyond that, there aren't any further repercussions. At that point, the property’s owner is able to rent out or sell the home as they wish.
Why Might A Lease Option Make Sense?
Lease options can be beneficial to both parties, but for different reasons. Let’s dig into why someone might enter into a lease option agreement.
Potential buyers have several reasons to consider entering a lease option agreement, including the fact that lease options:
- Offer greater flexibility: Lease options can be great for those who aren’t sure if they’re ready to commit to buying a home or know where they want to live.
- Lock in the purchase price: The landlord and tenant lock in the purchase price at the time the lease option is signed, so renters won’t have to worry about the sale price increasing, even if the market value does.
- Take the home off the market: A lease option prohibits the property’s owner from selling it to anyone other than the renter during the lease term, so there’s no risk of missing out on the home.
- Reduce barriers to homeownership: Renters in a lease option agreement have time to improve their credit score and save for a down payment before they buy the property, helping to reduce these common barriers to homeownership.
For sellers, a lease option might make sense because it:
- Increases rental income: Because renters in a lease option pay above-market rent, landlords can earn more in rent than they would with other types of leases.
- Could help a property sell: Some property owners choose to go the lease option route if they’ve had trouble selling the property previously, because it can make the property more attractive to potential buyers who aren’t yet ready to commit to the purchase.
- Combines the benefits of selling and holding real estate: Investors in particular often like lease option agreements because they can benefit whether they sell the property or continue to hold it in their portfolio.
Why Might A Lease Option Not Make Sense?
Of course, in addition to the potential benefits of a lease option, there are other factors to consider before you can confidently decide that it’s the best option for you.
The main risk of using a lease option for buyers is that there’s no guarantee of mortgage approval. If someone is denied a mortgage loan at the end of the lease term, they’ll have no choice but to forfeit the purchase option. For this reason, it may not be wise to use a lease option if you’re not sure you’ll be able to qualify for a mortgage.
For property owners, lease options might not make sense because there’s no guarantee of sale. A lease option might not be the best type of lease for property owners who know they’ll need to sell the property, since there’s no promise the renter will go through with the purchase.
Another risk for sellers entering into a lease option agreement is that the home could sell below market value. Even if the value of the property increases over the span of the lease, the seller remains obligated to sell the property for the amount specified in the contract.
Lease Option FAQs
Looking to learn more about lease options? Keep reading for the answers to some frequently asked questions.
Who should write a lease option contract?
A real estate attorney is likely the best person to write a lease option contract due to the nuances and financial commitment involved with this type of transaction. Your lawyer is also likely the best person to provide you with advice or clarification on any aspect of the contract that you’re unsure of.
Where can I find homes with a lease to buy option?
A real estate agent or REALTOR® can help you find lease option homes in your area. You may also be able to find a brokerage that has a dedicated lease-to-own program. Alternatively, you can also contact sellers directly.
Can I get out of a lease option agreement?
As a renter, you’re not contractually obligated to purchase the property, so all you need to do at the end of the lease term is walk away from the property. Sellers are legally bound to honor the lease option contract, and there could be legal ramifications to backing out.
The Bottom Line On Lease Options
A lease option is a type of real estate contract that gives renters the option to buy their rental when their lease is up. The property’s owner forfeits the ability to sell the property to anyone else during the lease term, and in exchange, the renter pays an upfront option fee and often a higher monthly payment. There are benefits and drawbacks of lease options for both the tenant and their landlord, so no matter which side of the transaction you’re on, be sure to carefully consider all factors before signing any sort of contract.
Is buying a home outright a better option for you than a lease option agreement? If so, start your mortgage application online with the Home Loan Experts at Rocket Mortgage®. You can also give us a call at (833) 326-6018.
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