Lease-options: the good, the bad, the ugly

REThink Real Estate

By Tara-Nicholle Nelson

10/23/2008 8:00:00 AM

Q: I owned a home for eight years, but borrowed heavily against it, took a subprime loan and recently lost it through foreclosure. My credit is shot from the foreclosure, but I have found another home I would like to buy. The seller will agree to do a lease-option, and I think it sounds like a great way to buy. What are the pros and cons of a lease-option that I should know about? Are there any pitfalls I need to beware of?

A: A lease-option arrangement may present a great opportunity for someone who has just gone through a foreclosure to immediately regain some of the benefits of homeownership. Before you enter such an arrangement, though, I'd urge you to cultivate order and clarity in your financial and life plans, and take several steps to protect your pre-purchase investment in the property.

Mindset Management

I recognize that due to your foreclosure, you might need to move quickly, and it seems ideal to move directly into a property under a lease-option. Before you agree to make any form of investment in such a property, though, spend a few hours examining the thoughts, actions and habits that got you into this situation in the first place. Get clear on where you must take responsibility for the overspending, excessive debting, underearning or undersaving -- now is the time for you to identify the poor decisions and destructive behavioral patterns in the context of your relationship with money that resulted, over the long term, in you losing your home.

This is not at all about blame or guilt -- probably the two most counterproductive emotional states known to humanity. This is about taking responsibility, the flip side of which is the ability to respond to your current circumstances in a manner that will allow you not only to survive through the foreclosure dilemma, but thrive in the future by rehabilitating your money- and mortgage-related habits and decision-making skills.

Obviously, part of what is attractive about a lease-option is that you have the option to buy or back out at the end. A lease option will usually involve you paying an option fee up front, or above-market rents -- or both -- in exchange for the seller's agreement to forego all other offers to buy the property for the term of your lease-option.

You must do this responsibility introspection (and experience the insights I promise you will have in the process) before you enter any lease-option so that you don't end up overpaying to secure a home that will present unsustainable financial obligations to you in the long run. Also, once you have clarity as to where your past missteps were, you will have fresh and potent motivation to carry out the perhaps less-than-sexy due diligence you need to avoid pitfalls and make the right decisions in terms of committing to a lease-option.

Need-to-Knows

In a lease-option, you rent the property from the seller/landlord for a period of time, under the agreement that you have the right to purchase the property at any time for an agreed-upon price. Lease-options have always been thought of as skewed slightly in favor of the buyer/tenant, who gets an option to buy or back out at the end of the lease, while the seller/landlord foregoes immediate cash and has to live with the uncertainty of the eventual outcome. However, in a market like today's, where some sellers often struggle to sell their properties at all, lease-options are coming back into vogue for sellers looking to secure a buyer for a tough-to-sell home.

Lease-options can present some incredible advantages for buyer/tenants, too! In this particular market, where mortgage money is hard to come by, credit and income requirements are tougher, and mortgage lenders want to see more down payment money, a lease-option allows a buyer/tenant the time to work on her credit and down-payment savings, while securing the property she wants to buy now.

Other lease-option benefits for buyer/tenants include:

• At least a portion of their monthly rent payments is not being thrown away, but will eventually go toward homeownership;
• You get to 'test drive' the home before committing to it;
• If you aren't sure whether you will stay in their neighborhood, town, job or relationship, you can get some time to see how things pan out;
• Buyers who want to move now but have their own home to sell can get time to sell their current home;
• Buyers can negotiate bargain-basement pricing with a motivated seller in areas where prices are still on the incline (they do exist!);
• If the market value of the home declines during the lease-option, you can simply choose not to buy the place at the end of the term, or renegotiate the price.

Of course, there are pitfalls, too. You should watch out for:

• Paying too large of an option fee up front or agreeing to pay an excessive purchase price or rental rate; having a Realtor to advise you on what is normal in your market really helps avoid this. The more of a buyer's market is, the less of an option fee you should pay -- maybe even none at all.

• Condition issues -- if you get into a lease-option with the intention to buy the place at the end of the agreement, you may want to have all the standard home inspections (e.g., pest, property and roof) before you sign the lease-option agreement to uncover any major condition issues up front, during the price negotiations.

• Sellers failing to make their payments on the property (so that it ends up in foreclosure), overencumbrancing the property (i.e., placing so much mortgage debt on the property that the option purchase price won't pay off all the loans), or selling the property to someone else during your lease-option period.

This last one is the big one -- the worst-case scenario: Buyer pays a $10,000 option fee, plus $500/month above market rents for two years of a 36-month lease-option; Seller stops making payments, and the property is lost to foreclosure. Buyer has no recourse but to take Seller (who's probably already broke!) to court, at potentially great time/money expense to buyer. To avoid this, get professional representation and investigate the type of loan the Seller has. Where the seller's mortgage is a loan that is set to have payments adjust to be significantly higher than the rent Buyer will be paying over the time of the lease-option, that is definitely a caveat emptor situation. Also, recording your lease-option with the county recorder will prevent others from buying or lending more money against the home without notice of your rights.

Action Plan

1. Introspection -- Get clear on the role you played in losing your former home, and take steps to improve your money patterns going forward.

2. Do some mortgage planning for the long term. Talk with a mortgage broker about a) what your down payment, monthly payment, taxes, etc., would be if you purchased the lease-option property on a long-term, sustainable mortgage, and b) developing an action plan for rehabilitating your credit and cash savings to position yourself to buy again. Get real with yourself as to whether the property you're looking at would be a sensible financial obligation for you over the long term.

3. Work with a Realtor or attorney to negotiate and document your lease-option agreement. Look to them for advice on standard practice regarding option payments, how much above-market rent to pay, and how much rent should be set aside by the landlord/seller each month toward your eventual down payment. Have a title search completed to understand the seller's outstanding obligations on the property. Then, follow all the way through and record your lease-option with the county recorder's office, once you're in contract.

Tara-Nicholle Nelson is author of "The Savvy Woman's Homebuying Handbook," and "Trillion Dollar Women: Use Your Power to Make Buying and Remodeling Decisions." Ask her a real estate question online or visit her Web site, www.rethinkrealestate.com.

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