Generally, a lease-to-own house purchase (also “rent-to-own purchase” or “lease purchase”) is a lease (regular house rental agreement) plus an option agreement, which gives you the right (without obligation) to purchase the property within a specified period, usually 3 years or less, at a price (or price formula) agreed-upon today. The option agreement gives you control over the asset (house) and for this option, the tenant/buyer pays an option fee, 1% to 5% of the price, which is typically credited to the purchase price when you buy. The tenant/buyer pays fair market rent and an additional rent premium to the seller, with the premium also credited to the purchase price. Lease-purchase plans make sense in many cases and have a solid economic rationale, which is why they exist.
As licensed professional mortgage brokers, we know exactly what it takes to qualify you for a mortgage and we do more than just get you a great mortgage at a great rate, we will show you the way, too.
A lease-purchase should have six major provisions.
1) The sale price of the house
2) The monthly rent which MUST be market-determined, yet subject to negotiation just as in a straight purchase or rental transaction, so doing your homework is advisable.
3) The option period (contract term) which is how long you get to get your own mortgage. Buyers generally prefer a long option period because it provides more time to build equity and repair credit. A long period can boomerang on the buyer, however, if they are never able to exercise the option, since they lose the rent premium they have been paying all the while, in addition to the option fee/down payment. Sellers generally prefer a short option period, but if it is too short, the house won’t be sold.
4) The option fee (some call it a deposit or down payment)
5) Rent premium. To the buyer, they are part of the equity in the house they will soon own. Fully anticipating that they will exercise the option, the only cost is the interest they would otherwise have earned keeping their money in their bank instead. To sellers, however, these payments are the best guarantee that their houses will sell; if they don’t sell, the payments are retained as income. On balance, these two factors combined give the lease-to-own deal a real possibility of being a win-win. Finally, a lease purchase may also give the tenant/buyer
6) The right to assign the contract. This will usually have considerable value to the buyer because it means that the option can be sold in the event that it has value, but the buyer is not able to exercise it. In other words, they get the right to substitute a buyer if they cannot conclude the transaction themselves. It is a cost to the seller for the same reason.
Firstly, a possible alternative to a lease-purchase deal for consumers with poor credit but with cash for a down payment is a “sub-prime loan”. Sub-prime loans are more expensive because there is additional risk associated with the borrower. However there are some available at reasonable rates from private lenders and local finance agencies. Borrowers can use the services of a qualified mortgage broker to search out these sources. Compare the total cost of financing (including interest, legal, lender and broker fees) against rent you would otherwise pay over the same term under a lease transaction. If you can qualify for a traditional mortgage right now or very soon, you may prefer that route instead of a lease-purchase.
The lease-purchase offers homeownership opportunities to consumers who can’t qualify for a loan from any source, but who are prepared to bet on themselves. The bet is that before the option period expires, they will qualify for a mortgage they need to complete the purchase. During the option period, they have the opportunity to build or rebuild their credit and accumulate equity while living in the house.
Consumers who need to rebuild their credit rating during the option period should understand that paying their rent on time won’t do it. Rent payment information is not used in compiling credit scores. While some lenders may assess a borrower’s credit in part based on “non-traditional credit data,” your credit score does not include rent payment information. Lease-purchase buyers who need a higher credit score to qualify for traditional lending must focus on improving their credit scores.
Even though it appears costly (risk of loosing down payment), the right to not exercise the option to buy is of value to buyers. If there is something not quite right with the house, neighbourhood, or neighbours, or there is a potential that you may have to move for work or other reasons, the money left behind on a lease-purchase could easily be less than Realtor fees and a mortgage payout penalty, had you bought instead and had to sell quickly.
Another considerable benefit to the buyer in a market where housing prices might fall is the ability to limit your downside risk to your foregone option fees. In the 2007-2009 correction in housing prices, the option buyer was the BIG winner, walking away in position to buy elsewhere at much lower prices. Conversely, when prices are rising, the option locks in the purchase price relative to the market when the contracts are signed. In 2005 and 2006 in particularly, market prices increased substantially and, once again, the option buyer came out ahead having secured the right to purchase the property at a price much lower than the current market prices. In a flat market, such as 2015-2017, keep in mind that if the agreed to purchase price might exceed the appraised price at mortgage time, and if so you will have to make up the price difference in addition to your down payment.
If you are prepared to invest your own time to find a property where the owner will provide some form of vendor-financing, and we think we can help you qualify for your own mortgage in short-order, we are prepared to help structure vendor-financing terms that are win-win for both you and the seller, and will hopefully keep you both out of trouble and disappointment. You just need to find the right property, and who can be better qualified to do that than you? PLEASE NOTE, WE DO NOT SUPPLY HOUSES, AND WE WILL ONLY RECOMMEND THIS STRATEGY TO YOU AND THE SELLER IF THERE IS A STRONG CHANCE YOU CAN GET A MORTGAGE SOON.
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1) How much money do we need for a down payment?
“The down payment required is typically a function of the purchase price and is subject to negotiation between the buyer and seller. We recommend at least 3% or $5000, whichever is greater, to ensure all participants are serious. If you can go higher then the monthly rental premiums will be lower. In either event, the objective should be that the combination of the two and your other savings will accumulate to the required down payment for lender financing at the end of your lease and option term.”
2) Does the down payment go towards the purchase price?
“When you buy, your entire down payment normally counts as a credit to the purchase price. Note, that we cannot say that it can go towards down payment, as only a mortgage lender can agree to that, assuming the deal is structured correctly.”
3) Do my monthly rent payments go towards the purchase price?
“Yes and No. Your monthly payment will generally consist of two parts. The first or base part should correctly be viewed as "market rent" and the second part viewed as a contribution towards your " down payment." When you eventually apply for your own mortgage, lender and CMHC rules dictate that only that portion of your monthly payment in excess of "fair market rent" (which must be established at the outset) can be used as down payment. So whether you are writing one monthly rent cheque with a fixed percentage credited back towards down payment or two separate cheques - one for rent, and the other as a credit towards your down payment - it's an accepted form of down payment savings IF IT HAS BEEN DOCUMENTED CORRECTLY FROM THE START.”
4) Why do we need to pay more above the rent?
“As in the answer to the first question above, the combination of down payment and monthly rental premiums are often calculated to enable you to accumulate the required down payment for mortgage financing by the end of your lease and option term."
Here's an example: Let's say your guaranteed purchase price is $300,000 and, when you go to qualify for a mortgage, the lender will require 5% down plus 1.5% available for closing costs: that's 6.5% of 300K or $19,500 required. Your rental premium is calculated such that when the time comes, you have ~$19500 in purchase credits. If you start with $10,000 down payment, and you need a 24 month term to establish your credit, a rental premium of ~$400/mo will land you in the right spot [$400/month x24 months + 10,000 upfront is $19,600]. Perfect! You want to make sure you can succeed with your rent-to-own purchase!
5) The down payment is too high!
“Consider all your options for down payment if you really want to be in this type of program. For example, many buyers borrow their down payment from a relative or parent willing to help. Others have some things with value that you could sell, or we could accept in trade. You might even be able to make extra payments over a short time frame to get to the minimum down payment. It's up to you and the home owner to negotiate, but keep in mind that lack of sufficient income leads to RTO train wrecks "
6) The monthly payment is too high. Can it be less?
“Perhaps you will be making more money in the next few months with a raise or more hours. Or maybe you'll be paying some debt off? Either of these might help you to afford the payment. Alternately, you and the seller can play with the numbers, perhaps with a bigger down payment or an increase in the end purchase price. But please NEVER get into a transaction you simply can't afford - it won't end well.”
7) What if we can't qualify for a mortgage in time?
"Based on the mortgage broker’s analysis and recommendations, there should be no reason you wouldn’t get qualified if you follow the advice as outlined (otherwise, we won't recommend you consider rent-to-own). This is a discussion you should have, however, with the seller and get it in writing. You may be able to negotiate that as long as you keep making the monthly payments you can't be asked to leave. The trade off may be that at the end of the option term that you agree on, your price lock will expire, and the purchase price will likely be adjusted to stay even with rising home values. Another solution is to get someone who can qualify for a mortgage to buy it instead."
8) Who pays for repairs?
"We recommend that you negotiate into your option agreement anything you have a problem with in the first 30 days the seller will take care of 100%. However, after 30 days, it's up to you just like when you own a home. You call the repairman, not the landlord. One of the conditions of most lease-option agreements is that you will be responsible for repairs. But make sure the seller will fix everything for the first 30 days so that you are comfortable that the house is in excellent condition. Also make sure you do a proper property inspection before you commit yourself to a property that you will eventually own - you don't want someone else's problems to become yours."
9) What does it take to qualify for a mortgage?
"Excellent question, because if you don't know what it will take to ultimately qualify for a mortgage, then why would you get into a contract you don't understand in the first place? The only way to successfully conclude your rent-to-own strategy is to succeed with getting a mortgage before your time runs out, so there is risk involved. If it turns out you can get a mortgage sooner than you think, then consider just keeping your money in your own bank account until you can get a mortgage pre-approval instead"
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10) I am in a rent-to-own agreement already, my time is running out, and I can't seem to mortgage qualify anywhere - what can I do?
"As mortgage professionals, we hear and see this all the time, and why the answers to questions 7 & 9 above are so important. You are now entering into a phase we call rent-to-own-rescue. Perhaps your agreement was not set up right in the first place, perhaps your credit never improved, perhaps you have too much debt - there are plenty of reasons why rent-to-own does NOT work. Your next steps depend on a number of factors, including whether or not the house is worth more than what you have to left to pay the owner. You are welcome to contact us and we'll review your options."
11) As the group advising on this program, how do you get paid?
"As mortgage professionals, our expertise is successfully arranging financing. When you ultimately qualify for your own mortgage, our hope is that you will arrange that mortgage through our office and we will earn a commission from the mortgage lender, as is the case with normal mortgage financing. Meanwhile and as it relates to this program, we typically charge a fee to the seller of the property to help them structure, present and arrange this financing option with you, due on the day you move in. You are welcome to contact us and we'll review your options. If you have a property in mind already, you are welcome to invite the property owner to contact us also and we can explore the opportunity together."