When You Can't Get A Home Loan, Here's Your Plan B

Most homebuyers require a mortgage to finance the purchase of their home. However, for some, the traditional route of homeownership may not be an option, since they might not qualify for such home loans due to their bad credit or insufficient capital to pay for the down payment.

This is where the lease-to-own model becomes a great alternative solution where you lease a home for a certain period, with the option to buy it before the lease expires.

Rent-to-own agreements consist of two parts:

1. A standard rent agreement; and
2. An option to buy.

The lease-to-own process is more sophisticated than the standard rental agreement; and therefore, it requires you to take extra precautions to decide whether it's a good option for you and then to protect your interests.

Related: Browse Discounted Properties Available For Lease-to-Own

Before I explain how lease-to-own works, here are key highlights of the process:

• A lease-to-own agreement is a deal in which you commit to renting a property for a specific period of time, with the option of buying it at a predetermined price before the lease runs out.
• You pay a lease option, which could vary between 10 - 15% of the property price. This lease option allows you to lock in an agreed purchase price throughout the lease period. You can exercise your option to purchase at any time within this period.
• You pay rent throughout the lease, and in some cases, a percentage of the payment is applied to the purchase price. In that way, you are accumulating equity every month the lease is paid.

How Does the Lease-to-Own Process Work?

There really isn’t a standard lease-to-own process; however, most transactions involve these components:

Purchase price

The lease-to-own agreement will specify the purchase price, which is often based on the home’s current value, and in some cases on an estimated future price. The buyer has the option to purchase the property, throughout the duration of the lease agreement, at the agreed purchase price, even if the property will be worth more in the future.

Lease payments

As part of the contract, you’ll agree to pay a certain lease (or rent) amount each month. These payments are usually higher than rent prices in the area because a percentage of each payment is set aside as a credit (equity accumulation) for your future purchase of the home.

Maintenance and Other Fees

In a lease-to-own agreement, the costs of repairs and maintenance are typically covered by the tenant. The same applies to service charges, utilities, HOA fees, and property taxes while you’re leasing the property.

Lease Option Fee

You’re required to pay the seller a one-time upfront, non-refundable fee, which is often referred to as the lease option fee. This allows you to buy the house at an agreed price, and in some cases, the seller will agree to put this amount toward the buyer’s equity in the home. The lease option fee typically ranges between 10% and 15% of the purchase price.

Lease term

You and the seller will agree to a specific lease term in the contract, which is typically 5 years. On the expiry of the lease term, the following options might play:

1. You will exercise your option to purchase: You will need to pay the balance of the purchase price after deducting the accumulated equity paid throughout the period of the lease.
2. The purchase will expire: This happens when you either decide not to move forward with the purchase or you’re unable to qualify for financing. In that case, all accumulated equity will be forfeited and all lease payments made (as well as the lease option fee) will be considered as made towards renting the property.

Exercising Your Lease Option To Purchase The House

At the end of the lease term, and if you decide to exercise your lease option to purchase the house, you will need to secure funds to pay for the balance. This means you should have evaluated your options of having those funds either through conventional financing or from other sources when you first signed the lease-to-own agreement.

Once you're ready with the balance payment, you will set a closing date where you’ll be given ownership of the property as the buyer. Depending on the terms of the agreement, the percentage of lease money set aside for your purchase and/or option money will be credited to you.

Related: The Simple Way to Invest in Real Estate with Little Capital

What Are the Lease-to-Own Pros and Cons?

Sounds like a great low-risk alternative to owning your dream home, right? Well, lease-to-own agreements have their pitfalls to watch for.

Pros for Buyers

You accumulate equity over time. Instead of having to put a 20% down payment (as is the case with conventional home loans), you put about half of that for the lease option when you move in, and then you build equity over time with each monthly lease payment you make.

You can lock in the purchase price at today's prices. At the end of the lease-to-own agreement, you won’t be up against other buyers who might be bidding for higher prices for the property. It's yours at the previously agreed price when you exercise your purchase option.

You don’t have to qualify for a mortgage right away. You may be drawn to a lease-to-own program because you can’t avail of a home loan yet. Moving into a house without qualifying for a mortgage may seem like the answer to your problem today, but you need to have a reasonable level of certainty that you can pay the balance of the purchase price by the date of the expiry of the lease agreement.

Cons for Buyers

Your lease will be more expensive than the rent. When your lease-to-own contract is set up so that part of your lease is going toward equity in the home every month, your rent prices are expected to be higher because of that.

You’ll pay a nonrefundable lease option fee. You will have to pay a percentage of the home’s price to have the option to purchase the home down the road. This a downpayment you won’t get back if the deal doesn’t work out.

You have to pay for repairs and maintenance. In lease-to-own agreements, it's usually the potential buyer's responsibility to pay for all repairs and maintenance.

Home values could go down. With a lease-to-own contract, you are locking in a purchase price from the date you sign the agreement. No one could predict where the real estate market or local economy could be heading few years down the line. Sure, your home value could go up, but it could also drop. If it drops, you could end up paying more than the property is actually worth in the future.

You could decide not to exercise your purchase option. Let’s say you still can’t qualify for a mortgage at the end of the contract term or just decide this house isn’t for you. If you’re in a lease option agreement, you can walk away from the contract, but all accumulated equity won't be paid back to you. Some sellers allow you to sell the property to another party at the agreed purchase price so that you can get back your equity.

Defaults in payments could terminate the lease. Defaults in lease payments or in case you break the agreement could trigger the landlord to terminate the contract. In that case, you will lose your accumulated equity.

Lease-to-own agreements are a great solution for you to buy your dream home, but you need to fully understand how it works and stick to the plan. When you feel you're ready, browse our hand-picked list of properties that are considerably discounted below market price at CasaBayt.