Renting with an option to buy is an attractive option for a consumer who wishes to become a homeowner but is not able to qualify for a mortgage. Sellers find these deals appealing because the deal terms are very owner-friendly, and buyers may wind up owning a home they can't currently afford. Unfortunately, there are significant risks, and both tenants and buyers should take care to evaluate the potential relationship before disappointment ensues.
Deciding on a Price
Tenants should approach the deal as a buyer would, and view the home as a long-term residence. Having an inspection and an independent appraisal before the deal is drawn up is a key element to success (tenants, or buyers, should pay for the inspection, while sellers should pay for the appraisal).
The tenant will not have an equity stake in the home until the lease has ended and a mortgage is secured, but the rent and the option fee will be derived from the purchase price.
The Option Consideration Fee
Once the purchase price has been decided upon, at the beginning of the lease the tenant pays an option consideration fee to the seller that guarantees the renter the right of first refusal on the eventual purchase of the home. This fee is negotiable and can range from 1 to 5 percent; 1 percent is the norm. At the end of the lease, the consideration fee is applied toward the purchase of the home. In the event that the tenant does not purchase the home, the seller retains the fee, a considerable risk for the tenant that may result in the loss of thousands of dollars.
The Lease Term and Rent Premium
After payment of the option consideration fee, the tenant moves in and begins making monthly rent payments to the seller, with an important distinction: the rent premium. The rent premium is an above-market payment to the seller that's also applied to the purchase, either partially or in full (this should be negotiated at the beginning of the lease). Like the option consideration fee, the rent premium is not refunded to the tenant if he fails to secure a home loan at the end of the lease term, which lasts anywhere from two to five years.
Risks and Challenges
The biggest risk to the seller is that the home value increases so much over the course of the lease term that the rent premium does not offset it. Of course, the home's price may fall over the lease term; in both cases, one side has little incentive to end the lease with a sale. Sellers should also make sure that they can afford to maintain two residences in the event that the tenant defaults.
Tenants especially should be very cautious, because if they are unable to qualify for a loan, then they will not be able to recoup the option fee or the rent premium. Saving as much money as possible during the course of the lease while also maintaining an excellent credit score is the best way to maximize the chance that a mortgage approval letter is in the cards.
Both sides should strongly consider hiring experienced, independent representation to negotiate the terms of the agreement.
- David Sacks/Lifesize/Getty Images