When you miss qualifying for a mortgage, you may be wondering if you have any options for buying a home. One avenue you might be researching is how does lease-to-own work?
Lease-to-own, also known as rent-to-own, is a way to begin the process of purchasing a property by renting it first. The main benefit of lease-to-own is that it allows the tenant time to build up credit and savings. It also grants the tenant time to see if the area and neighborhood are a good fit for their needs. We’re here to break it all down for you so you can decide if a lease-to-own agreement makes sense for your situation.
What Is Lease-to-Own?
A lease-to-own is an agreement between a landlord and a tenant that gives the tenant the right to buy the property after a specified amount of time. A portion of the rent paid may accumulate and be used for a down payment in the purchase transaction (the portion of rent held for the buyer is also known as “rent credit”).
Buyers may want to learn more about what is a lease-to-own agreement for a number of reasons, such as an inability to qualify for a traditional mortgage. The lease period allows the buyer to:
• Build their credit
• Save for a larger down payment
• Increase their income
• Try out the neighborhood
First-time homebuyers can
prequalify for a SoFi mortgage loan,
with as little as 3% down.
How Does Lease-to-Own Work?
The first step in entering into a lease-to-own agreement is to find a lease-to-own property. Since a lease-to-own agreement is a contract directly between a buyer and a seller, buyers need to find sellers who are willing to enter this type of arrangement. It can be difficult, since most sellers prefer a conventional sales arrangement. With lease-to-own, the seller continues to carry the mortgage while collecting rent from the buyer. (After a period of time, the buyer will have the option to purchase and will seek a home mortgage loan of their own to help pay for the property.)
To find a lease-to-own home, try one of these ideas:
• Use a real estate agent. Some agents specialize in rent-to-own programs and may be able to help you negotiate a lease-to-own contract with a seller or point you in the direction of a local program.
• Search a database. Some websites list homes that may be available for lease-to-own. You may be able to find these homes on websites such as HomeFinder.com, ZeroDown.com, or Renttoownlabs.com.
• Find a lease-to-own program. Some homes may be offered as part of a program similar to first-time homebuyer programs. In Home Partners of America or Divvy, for example, you find a home, the organization buys it, and then you sign a one-year lease (which can be renewed). At the end of the lease, the buyer agrees to purchase the property.
• Look for “For Sale By Owner” yard signs or online advertisements. A lease-to-own agreement may be worked out directly with the owner of the property.
Once you’ve found a property, you’ll need to ask for documentation that the seller truly owns the property and is up to date on property taxes and mortgage payments. Sometimes would-be buyers enter an agreement only to find that the house is in foreclosure.
If everything checks out, the buyer and the landlord will sign a Lease Purchase Agreement. A Lease Purchase Agreement is more complex than either a lease or a real estate purchase contract — it’s a contract where the lease agreement is tied to a purchase contract. What that means is once the lease period ends, the buyer agrees to purchase the property for a price set at the beginning of the contract. (Some deals are Lease Option Agreements, in which the buyer has the option to purchase the property but also has the flexibility to walk away; you can hire a real estate attorney to help you create the contract that best suits your needs.)
The buyer puts down a deposit, which can be used to secure the option to purchase the property at a later date.
Later, after the lease period comes to a close, the Purchase Agreement is executed. The buyer must first find financing to buy the property at the previously agreed-upon price. It may also be possible to renew the lease for another year if the buyer doesn’t have the credit or down payment requirements ready.
In the purchase contract, there’s typically a fair amount of rent credit that the buyer can use toward the down payment on the home if they’re able to move forward with financing.
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What Is a Lease Purchase Agreement?
Let’s dig deeper into what a lease-purchase agreement actually is. A Lease Purchase Agreement is a real estate contract consisting of two parts: a lease agreement and a purchase contract. In a Lease Purchase Agreement, a buyer leases a property with the intent of purchasing it down the road. At the end of the lease agreement, the buyer must secure funds, usually with a mortgage, to purchase the property.
Lease-to-own agreements are structured contracts that include the following:
• Names of parties
• Beginning and end date
• Option money fee
• Amount of purchase price
• Amount of rent credit (25%-30% of the rent is typical)
• Exclusions/inclusions of personal property (such as a washer and dryer)
Lease Purchase Agreements require the buyer to purchase the property in the future. A breach of one agreement voids the other. In other words, if the buyer breaks the lease agreement (such as by missing rent payments), they may not be able to purchase the property.
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How to Structure a Lease Purchase Agreement
Since a Lease Purchase Agreement is complicated, it needs to be structured to delineate terms and responsibilities clearly. Some examples include:
• Determine dates and length of contract. A Lease Purchase Agreement should have clear beginning and end dates and should spell out what should happen at the end of the lease agreement. Some experts recommended a year or less.
• List what the option fee is. The Lease Purchase Agreement will clearly disclose what the fee, if any, is for entering into the Lease Purchase Agreement.
• Determine how the rental agreement will work. You’ll have a lease contract that looks much like any other lease agreement when you’re a renter. Your landlord, the seller, may require a deposit, for example, and have guidelines for how the property is to be used. If the property is a condo, there may be bylaws that govern whether you can be in a lease-to-own agreement with the owner. There could also be restrictions on whether you can rent out an extra room while you are a tenant, or whether you can use the property as an Airbnb.
• Set the future purchase price. A Lease Purchase Agreement will include the home’s future purchase price. Properties can appreciate and renters may want to be sure they’re not going to pay a price that increases every year. Since you are locking in a price, it would be wise to have a home inspection just as you would a home you might purchase outright. After all, if the house has a serious flaw, that could be costly to repair and could affect its value — and in some agreements, the leaseholder is responsible for upkeep.
• Decide on how much of the rent will go towards the purchase price. This is negotiated between the buyer and seller. It is also known as “rent credit.” Sellers should be wary of allowing too much rent credit as this could allow legal issues to creep in.
• Clarify roles on home upkeep. In a lease-to-own situation, it’s less clear what party is responsible for maintenance and repairs. Be sure to spell this out in the contract before you sign. Tenants planning to become owners should be wary of making improvements that could become the property of the landlord.
• Seller should continue paying taxes and insurance. As the seller is still the owner, they should be responsible for taxes and insurance.
Pros and Cons Of a Lease Purchase Agreement
There are some pros and cons to consider if you’re looking at a Lease Purchase Agreement.
• Provides a path to homeownership for buyers who might not qualify for a mortgage or have a down payment
• Locks in the purchase price with a contract
• Allows the buyer time to build up credit
• Gives a buyer time to increase income
• Helps buyers save for a down payment
• Makes it possible for the buyer to “test out” the neighborhood
• Ability to earn rent credit or rent equity to go toward the down payment
• Buyer may have higher monthly rent or upfront fees
• Buyer could lose their deposit, option fee, and rent equity if the purchase doesn’t work out
• Buyer may not qualify for a mortgage when the contract is up
• House could be in bad shape
• Seller could be a scammer who doesn’t own the home, is behind on taxes, doesn’t keep the home in good repair, or is in danger of being foreclosed on
For a lease-to-own situation to make sense, you’ll want to look at the fine print. Consider the fees, interest rate, terms, rental contract, and property condition. If you need to get into a house ASAP and don’t have the right credit score or down payment, then a lease-to-own agreement might make sense. If the terms of a lease-to-own contract are not favorable enough for your situation, see what it takes to get back on track towards qualifying for a mortgage.
Looking for an affordable option for a home mortgage loan? SoFi can help: We offer low down payments (as little as 3% - 5%*) with our competitive and flexible home mortgage loans. Plus, applying is extra convenient: It's online, with access to one-on-one help.
Is it a good idea to lease-to-own?
Whether or not a lease-to-own program is worth it is highly dependent on an individual’s situation. It’s a great idea for those who want to build up their credit, need time to save more money for a down payment, or want to see if the area is really one they want to live in, but you’ll want to do your research on the property and work with an attorney to ensure your rights are protected in the agreement.
What is the downside to lease-to-own?
If the lease-to-own arrangement doesn’t work out, or if the property owner fails to pay property taxes or make their mortgage payments, you may risk losing your deposit, down payment, and any equity you’ve earned with your rental payments.
What is the difference between lease-to-own and lease?
With lease-to-own programs, the renter may have the obligation (or an option) to purchase the property at the end of the contract. Also, it’s common for part of the money you pay in rent to accumulate toward your purchase price. None of this applies with a standard lease agreement.
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*SoFi requires Private Mortgage Insurance (PMI) for conforming home loans with a loan-to-value (LTV) ratio greater than 80%. As little as 3% down payments are for qualifying first-time homebuyers only. 5% minimum applies to other borrowers. Other loan types may require different fees or insurance (e.g., VA funding fee, FHA Mortgage Insurance Premiums, etc.). Loan requirements may vary depending on your down payment amount, and minimum down payment varies by loan type.
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