Updated: 9/29/2010 9:00 AM ET|
Renting to own: Don't get burned
Lease options can help buyers with bad credit get into homes they're not qualified to purchase otherwise. The pitfalls are many, but there are smart ways to avoid them.
When Lizabeth Hunt moved from Chicago to Florida in 1993, she wanted to buy a home, but financial struggles had taken a toll on her credit history and bank account. Still, she couldn't help but look.
During the rainy season in Florida, Hunt kept seeing a patch of blue sky over Hollywood Beach. There she found herself driving past the perfect condominium, again and again. But she told herself she could never live there.
Finally, Hunt decided to approach the seller with the idea of renting to own.
Here's the way it works: A tenant pays higher-than-market rent, and the excess goes toward a down payment. It's called a lease option, or lease with an option to purchase. The tenant agrees to lease the home for, say, two years, with the option to buy the home at the price stated in the contract.
If the tenant decides not to buy the home when the option expires, the homeowner keeps the extra rent and an upfront fee, usually a percentage of the purchase price. If the owner breaks the contract by selling the home before the option expires, the tenant gets that money back.
Lease options are often used by people like Hunt who want to buy a home but need more time to clean up their credit histories or save up a down payment. In a rising market, there's the appeal of locking in a lower purchase price.
But the deal can easily go awry. Here are the three biggest problems you could face and how to avoid them.
Problem 1: You pay too much for a home
You have less negotiating power when you rent to own than when you offer to buy a home outright. That's because most sellers would prefer to sell the home, get out from under the mortgage and take the equity. They'd rather not wait to see whether the tenant will decide to buy or will qualify for a loan. Owners generally aren't interested in a lease option unless they are having trouble selling their home, such as during a slow housing market.
Knowing that prospective buyers don't have many options for buying a home, sellers sometimes price the home above market value. Hunt knew this going in.
"The whole idea of lease to own is that the seller is (taking) a risk with you," says Hunt, who worked for a developer who used lease options. "There's a chance you could tie up the property and not be able to get a loan, or you might walk away."
Tenants need to be careful in making an offer. "Very often the buyer is so excited that somebody is letting them in with little or no money that they never get the house appraised," says broker and appraiser Jane Mostow. "When they go to buy the house, they find it's not worth it."
This can be a problem when home prices are falling. If the price is out of line, it's very difficult to get financing.
Problem 2: You could lose your investment
Just a couple of nightmare scenarios: The homeowner doesn't make the mortgage payment, and the bank forecloses. Or the homeowner tries to force you out to sell to a higher bidder.
The landlord, Mostow notes, is essentially saying: "'I'll allow you to rent my house. When you give me the money, I'll turn around and make my mortgage payment.'
"What if they don't make that mortgage payment? The person in on the lease option has no protection," Mostow says.
The bank does not have a contract with you -- whether you've been paying your rent or not -- so in a foreclosure situation, you'd lose your money.
How much? Fees are generally 1.5% of the purchase price. On a $200,000 home, that's $3,000. If you'd negotiated to have, say, $200 of each month's rent applied toward the down payment, after two years you'd have paid $7,800 total (not including the rent you pay at market rate).
In most cases, the landlord wants you to exercise your option and buy the home. But sometimes the landlord changes his mind. Perhaps housing prices have gone up and he thinks he could sell the home to someone else for more money. Then he might try to make it difficult for you to buy. If the terms of the lease option are written in his favor, you could lose your option to buy with just one late payment.
Problem 3: You might never be able to buy the home
Can you really afford the home? At this stage, there's no bank telling you otherwise. Some landlords will take a lease-option payment even when they know the buyer has no hope of ever qualifying for a loan.
Most lease-to-own buyers are unable to get a conventional loan because of bad credit. They need to be committed to improving their credit scores.
"The whole idea of a lease option is that eventually (buyers) qualify for a mortgage," says Matthew S. Chan, the author of the "TurnKey Investor" series of books. "But they've got to clean up their credit. People think two to three years is a long time. It blazes by for many people. Unfortunately, their habits die hard. The things that make them have bad credit continue."
Make the deal work for you
Still want to take the plunge, locking in the price on a home now? Educate yourself first.
"You cannot get enough education," Chan says. "If you want to talk to an attorney, do it well before you seal the deal. Get somebody on your side."
Learn about lease options from the landlord-owner's perspective on Chan's website, TurnKey Investing. Chan says, "I think it is very helpful for purchasers to understand the landlord-owner side so they don't get taken advantage of."
Be wary of sites that promise quick riches and push too hard to sell products. Another source of information, from the renter-purchaser perspective, is Robert Irwin's book "Rent to Own: Use Your Rent Money to Get Started Owning Real Estate."
Find a home at a fair price
The easiest method is to find a home that's advertised as "rent to own." It limits your choices, though, if there are few in your area. Another option is to find a home for sale and ask the owner whether he is willing to lease the property. That's what Hunt did.
Hunt called the owner of her dream condominium from the parking lot and asked to see it. He said, "Give me five minutes." As he showed her the condo, she talked to him about why he was selling and asked him whether he would consider a lease-to-own deal.
"Don't use the technical term if possible," Chan advises. "'Lease option' will throw them for a loop. Say, 'Would you be willing to sell this property at a pre-agreed price if I make my payments on time for the next two or three years?'"
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