Lease purchase agreements and lease-to-own agreements: What you should know

Whether it’s having to come up with the money for a down payment or trying to find a lender that’ll approve you, sometimes there are barriers that could prevent you from becoming a homeowner. Choosing a lease-to-own or lease purchase agreement can be a more flexible alternative. You rent now and have the option to purchase the home later.

Learn what these types of financing arrangements are and whether they could be a good choice for you.

What is a lease-to-own agreement?

A lease-to-own agreement, or a lease option, is a contract between the tenant and landlord for the tenant to purchase the home at a later date. The tenant pays an up-front fee based on the home’s purchase price, giving the tenant the exclusive right to purchase the property.

When drafting the contract, both will agree on the purchase price, the end of the lease date, and the portion of the rent that goes toward the down payment. At the end of the term, the tenant will need to secure a home loan to purchase the property. 

How does a lease-to-own agreement work?

A lease-to-own agreement outlines the up-front option fee, lease period and the portion of the rent payment that will contribute toward the home purchase.

During the lease period, the tenant pays the rent and will follow the terms set out in the contract. They’ll also need to follow any applicable local and state tenant laws. When the lease period ends, the tenant can let the agreement end or choose to purchase the property.

If the tenant decides to move forward and buy the property, the options and some of the rent payment will go toward the purchase price. Otherwise, the funds are forfeited if the agreement is terminated.

What is a lease purchase agreement?

A lease purchase agreement is a rent-to-own contract, where a tenant will buy a property on a specific date. Both parties will sign the contract after agreeing upon the terms.

How does a lease purchase agreement work?

The lease agreement details the up-front option fee that grants the tenant the rights to purchase the property at an agreed-upon price at the end of the lease term. Plus, other terms are specified, such as the lease end date, and how much of the rent payment will be applied toward the home’s down payment.

When the lease term ends, you’ll either need to secure a mortgage or come up with another financing option, or risk losing the right to buy the home. You will also forfeit the up-front option fee and any payments that would have gone toward the down payment.

Differences between lease option and lease purchase

The difference between a lease purchase agreement and a lease option agreement is that the lease option requires the landlord to sell the home if the tenant wants it. 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.

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. In that sense, they’re both rent-to-own agreements.

Pros and cons of lease purchase and lease-to-own agreements

Understanding the benefits and drawbacks of both lease purchase agreements and lease-to-own agreements is key. While it’s set to benefit both the landlord and tenant, there are still risks with this type of arrangement.

Benefits

Some of the benefits include the ability to make a down payment using the rent payment and the potential to attract quality tenants.

How the buyer benefits

• Down payment: The tenant can finish the lease term with a significant down payment by simply paying rent. However, the rent may be higher than market rates to account for the down payment.
• Convenience: Rather than move again, the tenant can offset moving expenses and hassle by simply buying the home they’re already in.
• Credit score: The lease purchase agreement gives the tenant an opportunity to boost their credit score or resolve any credit issues before securing a home loan.

How the owner benefits

• Large up-front payment: You get to keep the option fee even if the tenant decides to let the lease agreement end or is unable to hold up their end of the contract.
• Attract tenants: Though there’s no guarantee, these types of arrangements may have a higher chance of attracting responsible tenants who will better maintain the property.
• Default benefit: You get to keep the down payment if the tenant defaults or breaks the agreement.
• Locked-in sales price: Setting the purchase price in advance lets you predict how much you stand to profit when the lease term ends.
• Simplified selling process: The landlord is able to transfer ownership on the property on the closing date without having to drag out the timeline, like having to work with a real estate agent.

Risks

Both buyers and sellers can face legal or financial risks when engaging in lease purchase agreements.

Risks for buyers

• Mortgage uncertainty: You will need to secure financing, like a mortgage to purchase the home at the end of your lease term. If you’re not able to do so, you’ll need to find another place to live, unless your landlord agrees to keep renting to you.
• Potential entrapment: Tenants could feel trapped and locked into a price that they don’t like later on. That’s why it’s important to read the lease agreement carefully and seek legal advice before signing it.
• Cancellation limitations: Failing to understand the terms and what your obligations are could lead to consequences like additional fees or contract termination.

Risks for sellers

• Buyer profile differences: Rent-to-own buyers may be different from traditional buyers. For example, they may not end up having the means to purchase the home later on, or aren’t as committed to buying the property.
• Contractual obligations: Sellers need to follow the contract, even if they’re tempted to sell early or to a higher bidder. Or, if home values have gone up, they won’t be able to sell and may lose out on the opportunity to earn a larger profit.

Market risks affecting property value

Home values can fluctuate during the lease purchase term, which can significantly increase or decrease. These shifts are risky for both buyers if values fall, and for sellers if prices go up. Unless arrangements are made, both the buyer and seller are locked into the original agreed-upon price.

How to structure a lease purchase agreement

Lease purchase agreements often include two separate contracts: one for the lease agreement and the other for the end-of-lease sale. Each of these contracts may include cross-default provisions that can make certain clauses mutually exclusive. In other words, if the renter breaches one provision like missing a monthly payment, it could trigger a breach in the purchase contract.

As a seller, here’s how you can structure yours.

1. Set the lease period

The lease needs to specify how long the lease period will be and the monthly rent amount. Lease purchase agreements typically have longer terms for the lease up to 3 years.

2. Include special clauses

The lease agreement should include all standard lease terms along with some special clauses, such as requiring the tenant or buyer to pay for maintenance costs, property taxes, and insurance.

Other key clauses to include are the option fee amount, purchase price, and down payment. The option fee will legally bind the agreement, where the landlord agrees to sell the property at the end of the lease term. This fee is nonrefundable.

3. Allocate portion of rent to the down payment

You may choose that a portion of the monthly rent payment go toward the down payment. These “credits” will accumulate over the lease term.

For example, the monthly rent is $2,000 on a home valued at $250,000, and $400 each month goes toward the down payment. After a 24-month lease, $9,600 has accumulated, resulting in a 3.8% down payment.

If the buyer decides the house isn’t for them and backs out of the sale, they forfeit the down payment.

4. Include a contract of sale

This section of the agreement outlines the purchase process and other terms at the end of the term lease. Both parties agree to the purchase price no matter how the lease agreement is at the time the agreement is signed. Often, the purchasing price will be higher than the fair market value to account for appreciation. Both parties are bound to this agreed-upon purchasing price.

When the lease term ends, the buyer will be responsible for securing a mortgage on the property. Documentation that the buyer has paid toward the down payment may help with financing.

If the tenant is able to secure financing, the lender will send the funds for the home purchase to the seller to complete the title transfer.

5. Have a professional review your contract

When the purchase agreement is drafted, it’s important for the seller to review it before giving it to the tenant or buyer. Doing so will help ensure that the agreement is intact and terms are clearly outlined.

The buyer could benefit from working with a real estate attorney to review the agreement as well. For instance, most agreements will nullify the contract of sale if the buyer can’t secure financing, some will require full repayment whether the renter can afford it or not. Having a professional review ensures that the buyer is also protected.

The bottom line: A rent-to-own agreement may be the right option

A rent-to-own agreement may be a great choice if you’re renting and want a longer period to secure a mortgage and make a down payment in smaller increments over time. It may be more affordable than trying to search for and purchase a home outright.

For sellers, it’s a great option because these arrangements may attract higher quality tenants and earn more cash up front.

When negotiating between the tenant and landlord, it’s key to differentiate between rent-to-own and a lease purchase. Although both are similar, one locks you into a purchase, whereas the other gives the tenant the option to back out when the lease agreement ends.

Whichever option you choose, be sure to review any documentation with a real estate attorney before signing on the dotted line.

Nearing the end of your lease or rent-to-own agreement and looking for financing options? Either way, knowledge is power. Learn more about your options with Rocket Mortgage today.

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