Lease Purchase Agreement: What You Should Know
February 02, 2024 6-minute read
Author: Victoria Araj
Rent-to-own contracts are very appealing to prospective first-time home buyers who need more time to build up their credit scores or save for a down payment. Lease purchase agreements are arguably the most legally binding of the various rent-to-own options.
Learn what’s at stake and if it’s the right option for you with our in-depth breakdown of a lease purchase agreement and its benefits.
What Is A Lease Purchase Agreement?
A lease purchase agreement in real estate is a rent-to-own contract between a tenant and a landlord for the former to purchase the property at a later point in time. The renter pays the seller an option fee at an agreed-upon purchase price, giving them exclusive rights to buy the property.
Both parties agree to what the purchase price of the home will be at the end of the lease term. The agreement will likely include a stipulation that a portion of the monthly rent goes toward a down payment. The renter should be confident that they can secure a mortgage at the end of the lease, or else they forfeit the purchase option.
Lease purchase agreements are often confused with lease option agreements because they both share that crucial, nonrefundable option fee. Both prohibit the landlord from selling the property to anyone else during the lease term and give the tenant the option to purchase at the end. However, that’s where the similarities end.
The difference between a lease option and a lease purchase agreement is that the lease option only obligates the seller to sell. A lease purchase agreement commits both parties to the sale barring breach of contract or the buyer’s inability to secure a mortgage. Buyers are also typically required to pay for maintenance costs, property taxes and insurance and can expect to pay higher than fair market rent to contribute to a down payment.
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How To Structure A Lease Purchase Agreement
Lease purchase agreements often include two distinct contracts: one for the lease agreement and the other for the end-of-lease sale. These two different contracts will include cross-default provisions that make certain clauses mutually exclusive. That is, if you breach one provision, such as missing a monthly payment, it may trigger an automatic breach in the purchase contract.
The lease agreement will include all the standard elements of a traditional lease along with a few special clauses, such as requiring the buyer to pay for maintenance costs, property taxes and insurance fees. Unsurprisingly, the lease should outline how long the lease period will be and the monthly rent amount. Lease purchase agreements will often have a longer period for the lease, typically up to 3 years.
Some special clauses to look out for include the option fee amount, purchase price and down payment. Both parties will agree to an option fee, which legally binds the landlord to sell the property to the tenant if they so choose at the end of the lease, even if the landlord changes their mind. Such an agreement comes at a cost. The option fee can be any amount and is nonrefundable.
This portion of the agreement will also typically allocate a dollar amount of rent that will go toward a down payment. Let’s say a renter is paying $2,000 a month on a $250,000 home, and $400 per month goes toward a down payment. At the end of a 24-month lease, the buyer has the option to use $9,600 as a down payment of 3.8%, just above the minimum for most mortgages. If the buyer decides the house isn’t for them and backs out of the sale, they forfeit the down payment.
Contract Of Sale
This agreement will outline the purchasing process and terms once the lease period has lapsed. No matter how long the lease term is, both parties will agree on a purchasing price (based on fair market value) at the time of the rental agreement. Often, the purchasing price will be higher than the market value to account for appreciation. No matter which direction the market fluctuates, both parties are bound to this agreed-upon purchasing price.
The buyer will be responsible for securing a mortgage loan on the property. If the tenant was unable to qualify for a mortgage before signing a lease purchase contract, they’d be able to share their agreed-upon down payment timetable with the lender as leverage for a better deal. At the end of the residential lease, the lender will transfer the funds to the seller to transfer the title.
It’s highly recommended to have a real estate attorney review this contract before signing. While most often, the agreements will nullify the contract of sale if the buyer can’t secure financing, some will require full repayment whether you can afford to or not. That’s why it’s usually a good idea to seek legal advice when entering into any kind of real estate purchase agreement.
Benefits Of A Lease Purchase Agreement
Of course, a lease purchase agreement is set up in such a way to benefit both parties. Both enjoy a certain degree of risk with housing market fluctuations and comfort with a locked-in purchasing price.
How The Buyer Benefits
A lease purchase agreement can be attractive to renters and first-time home buyers for a range of reasons. Here are the most common:
- Down payment: The tenant will finish the lease term with a considerable down payment saved by simply paying rent. That said, the agreed-upon rent payment is also likely to be higher than the market value for this same reason.
- Convenience: Rather than move again, the tenant can offset those moving expenses and hassle by simply buying the home they’re already in.
- Credit score: If the buyer doesn’t have a qualifying credit score for a mortgage, a lease purchase agreement can give the buyer time to repair their credit score or other credit problems while working towards homeownership.
- Build equity: If the property’s value increases above the agreed-upon purchasing price, the buyer has already built equity in the home.
How The Owner Benefits
A lease purchase agreement can benefit the owner in some of the following ways:
- Large upfront payment: The property owner will get to keep the option fee even if the buyer defaults.
- Attract tenants: If the owner is having a hard time finding tenants, they can attract responsible renters who are more likely to properly maintain the property.
- Default benefit: If the tenant defaults on the contract, the owner keeps the down payment at the end of the lease term.
- Locked-in sales price: The owner can choose the purchase price in advance. This can be good or bad depending on the housing market value fluctuations.
- Simplified selling process: The landlord doesn’t need to go through the normal sales process with a real estate agent or REALTOR® and can simply transfer ownership on the closing date.
The Bottom Line: A Rent-To-Own Agreement May Be The Right Option For You
Treat lease purchase agreements as seriously as you would a home purchase because that’s what it is. Lease purchase agreements can benefit property owners with hard-to-sell homes and renters who need more time to qualify for a loan. Be sure to review any agreements with a lawyer ahead of time.
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