Lease-Option Contracts & Regulatory Limitations

So, you began renting your home a couple years ago, and now you’ve decided to exercise the purchase option of your lease-option (sometimes also referred to as a lease purchase or rent-to-own) agreement.  Simple, right?  Not always.

As the buyer, you will usually need a mortgage loan – and oftentimes, if you’ve been in a lease-option arrangement, there is at least an understanding between you and your landlord that some or all of your accrued rent will be applied to the purchase of the home.  There are a few ways that this can be handled, but it’s important to check with your lender to determine the best choice for you.

Many lenders face regulatory guidelines (some internal, some external) that either (1) limit the maximum amount of such a credit or (2) dictate how the accrued funds can be used toward the loan.  It is important to be aware of these regulations and guidelines as you negotiate your purchase contract so that you and your agent can factor in appropriate seller credits when crafting your offer and avoid overestimating what the seller can provide.  Consider these two scenarios:

  1. You and the seller/landlord agree to a sale price of $250,000.  You also agree that $300 of your monthly rent payment will accrue toward the sale price.  So, after two years of renting, you have accumulated $7,200.  Then, when you execute the purchase contract, the new sale price is $242,800 for the bank’s purposes.
  2. You and the seller/landlord agree to the same sale price and rate of accrual, but your lease-purchase agreement states that the accrued $7,200 will be used toward your down payment and the purchase price will remain at $250,000.

Scenario #2 can get sticky.  Since the seller has your funds, most lenders would view these funds coming back to the buyer as a “gift” – but gifts are not typically permitted from non-relatives.  The same funds, however, can be used toward closing costs (also known as seller-paid concessions).

Essentially, you can draft a lease-option agreement with your landlord that contains just about any terms that you wish.  But it’s essential to remember that the terms you agree on might not necessarily mesh with the guidelines that the lender will ultimately set forth.  Items such as the maximum allowable seller concession, the “Market Rent” as determined by an appraiser, any minimum down payments for the loan, etc. will all have to be factored in when deciding to exercise your option to purchase.

How a buyer takes full advantage of any accrued entitlement will vary from case to case, but it will almost always require careful negotiation with the seller and clear communication with both your real estate agent and mortgage loan officer.  A contract that applies too large an amount or percentage of accrued rent to the purchase may not survive underwriting. To overcome this, buyers and sellers must remain flexible and willing to (re-)negotiate certain fine points of the purchase contract in order to work around the regulatory obstacles and still reach the mutually beneficial result – the sale.  Always seek the assistance of your lender “before” entering into the lease-option agreement.

Note:  The three terms (lease-option, lease purchase, and rent-to-own) are often confused with one another.  There are distinctions.  A lease-option is generally for one or two years with an “option” to buy at the end of the term, but no obligation to buy.  In a lease purchase, you are renting for a time (six months is pretty typical – essentially you have early occupancy) and close on the purchase at the end of the term.  In other words, you entered into a purchase contract and agreed on the price at the beginning; your closing date is just pushed out further than usual while you “rent” or make use of extended early occupancy.  In a rent-to-own situation, the tenant pays extra rent that is held until enough money is accrued to make one of the first two options possible.  The differences among the three are subtle, but can be very important; thus the need to employ the assistance of both a Realtor® and your mortgage specialist in advance of entering into any of these agreements.  Also note that different states may have different rules regarding these options.