Lease option: Definition and how it works

If you’re considering buying a home but are not yet ready to commit, you may wonder if getting a lease with the option to buy will be the best of both worlds.

A lease option is a type of contract that can offer some additional flexibility as you decide whether you should buy or rent, but it isn’t always the best choice for everyone. 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 the option to buy, is a real estate contract that gives renters 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 purchase the property. Part of the rent will include additional monthly fees toward the down payment.

A lease option also prevents the property owner from selling it to anyone other than the tenant during the lease term. Should the renter forfeit the option to buy at the end of the lease term, they lose the option fee and any money put toward a down payment.

Lease option vs. lease purchase agreement

A lease purchase agreement differs from a lease option because it requires both parties to follow through with the sale at the end of the lease. With a lease option, the renter isn’t obligated to follow through with buying the property.

What will you find in a lease option contract?

A lease option contract includes several key pieces of information:

• Lease term: This will 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 owner an option
• Purchase price: Regardless of whether the renter ultimately buys the property, the purchase price will be stated.
• 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. Homeowners insurance can help ensure that the home can be repaired if damage occurs.

Lease with option to buy: How it works

Let’s take a closer look at how lease options work.

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 paid 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.

When does a lease option make sense?

Lease options can be beneficial to both parties. Let’s explore why someone might enter into a lease option agreement.

For buyers

Potential buyers should consider the following reasons for entering a lease option agreement:

• Greater flexibility: Lease options can be great for those who aren’t ready to commit to buying a home or know where they want to live.
• Locked-in 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.
• Home taken off the market: A lease option prevents 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.
• Reduced 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

For sellers

For sellers, the following factors might make a lease option appealing:

• Increase in rental income: Because renters in a lease option pay above-market rent, landlords can earn more than they would with other leases.
• Could help a property sell: Some property owners choose 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 may like lease option agreements because they can benefit whether they sell the property or continue to hold it in their real estate portfolio.

When does 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 it’s the best option.

For buyers

The main risk of using a lease option for buyers is that there’s no guarantee of getting approved for a mortgage loan. If you’re denied a loan at the end of the lease term, you’ll have 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 sellers

For property owners, lease options might not make sense because there’s no guarantee the renter will go through with the purchase. So, a lease option might not be the best type of lease for property owners who know they’ll need to sell the property.

Another risk for sellers 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 a great option to provide advice or clarification on any aspect of the contract 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 look at a brokerage that has a dedicated lease-to-own program. Alternatively, you can 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 backing out could have legal ramifications.

The bottom line on lease options

A lease option is a type of real estate contract that allows renters 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 a 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.