When buying a home, there is more than one way to finance the home. Most people arrange financing through a bank, called the mortgage. Instead of borrowing the money from the bank, it is also possible to borrow the money from the home seller. This is known as an owner financed transaction. Another common way to own a home is to promise to buy the home with a mortgage in the future and make monthly payments to the seller until that time. This is a lease option. It is in essence renting the home, but with the option to purchase at a pre-determined price if you want to. For both the buyer and seller of a lease option, there are advantages and disadvantages. For the seller of a lease option, the advantages and disadvantages depend mostly on your personality and the amount of equity you have in the home.
For most people, a lease option is no option. When I ask people if they would consider a lease option, very very few say yes. When asked why, the answers vary from just not knowing how it works to not willing to take the risk. Though there is greater risk in a lease option over a direct sale, there are also greater potential rewards. The risk adverse person may not want to offer a lease option though the risks are generally less than what you are exposed to in the stock market. In the follow article, we will discuss the advantages and disadvantages of offering a lease option when selling your home.
The main advantages of a lease option for a Seller include (1) More potential buyer for your home (2) getting your asking price or more for your home (3) passive income. If you were also considering a rental, there are additional advantages. These include (1) a substantial upfront payment (2) occupant has vested interest in keeping the home in good condition (3) occupant is responsible for replacements and repairs, not the owner.
The major disadvantages of a lease option for a seller include (1) limited access to home equity (2) still responsible for the mortgage whether the occupant pays you or not (3) risk of damage to the home by the occupant (4) loss of access to future property growth. Each advantage and disadvantage will be discussed more specifically below:
1. Advantage: Having an immediate buyer. Like all free trade markets, the housing market continually shifts between a buyer’s and a seller’s market. In a seller’s market, buyers are readily available and willing to pay asking price or more for the home. However, eventually all seller’s markets turn to buyer’s markets. At this point, there are few buyers, who can take their time and offer less for your home. A common driving force for a buyer’s market is higher interest rates and a lack of readily available financing. In this scenario there are fewer buyers because a substantial percentage of the buyers cannot get financing through conventional means. In the current market, credit is the major issue. Banks are having to hold fast to their cash reserves to stay afloat and are only willing to provide mortgages to only the best credit scores. In this situation, there is a glut of buyers sitting on the sidelines, with plenty of cash flow to own a home but lacking the credit to buy a home. Offering a lease option gives these buyers a chance to purchase you home when otherwise they could not. For the person in a hurry to sell their home this could mean everything.
2. Advantage: Typically for a seller to agree to a lease option, the buyer needs to agree to purchase the home in the future at the asking price or at a higher price. The seller is yielding up their future appreciation to the buyer by setting a permanent contract and should expect to get their asking price or more. The seller should also expect to get some money down to partially cover the risk of the person choosing not to exercise their option.
3. Advantage: Along with the favorable selling price, the seller will also receive monthly payments to cover the seller’s monthly expenses and possibly more. How much more depends on the conditions in which the seller bought their home. If the interest rate is lower than the current rate or if there is equity in the home, the monthly payment the buyer would be expected to pay will be more than the monthly expense. The difference is income with virtually no work involved. There is probably not much hope for passive income if you have a high interest rate adjustable mortgage with negative equity, but in that situation, a short sale of your home may be a better option if available.
4. Advantage: Lease options are considered less risky than renting because of the down payment the buyer makes and the vested interest the buyer has in the home. I personally would not consider a lease option if the buyer did not offer a significant down payment because it would be too much like renting. Something that I find a little risky for my tastes. However, with a lease option, the buyer is expected to make a down payment to secure the advantages of the option, including access to future appreciation. In the lease option, the buyer has two very good reasons to keep the home: the down payment and the potential of equity growth. Unlike a rental, the home has been sold; it is just the transaction that will occur in the future. The buyer is now responsible for the maintenance and upkeep of the home, not the seller.
5. Disadvantage: One big disadvantage of a lease option is limited access to the home equity. When you offer a lease option, you must maintain your current mortgage and any other loans on the home or pay them off yourself. If you have thousands of dollars in equity in the home, that money will not be made available until the lease option is exercised. Sure, you could refinance your mortgage to get the equity out, but will incur the costs of the refinance and a higher interest rate, which is probably not worth it. As such, the rate of return on your money over the life of a lease option is dependent on how much equity is tied in your home. With little to no equity in a home, a lease option can result in a very high relative rate of return on your money. Even with a lot of equity, the option can be quite profitable.
6. Disadvantage: A lease option is an expressed intent by the buyer to purchase your home in the future. They pay you some money down, but have no obligations except to pay you a monthly payment until that time. However, there is a risk they do not pay you on time or at all. However, as far as your own mortgage is concerned, it must still be paid, and if the occupant has not given you the money to pay the mortgage, you must dig into your own pockets to find the money. Fortunately, you have the down payment to fall back on though only for a while. A lease option is a safer bet when you have enough income to afford that second mortgage payment.
7. Disadvantage: If the lease option buyer chooses not to buy the home during the lease period, then the home falls back to your possession along with the costs of repairs, if any. If they do not exercise their option, you do get to keep the down payment which helps to pay for any restoration provided the repairs do not exceed the amount of the down payment.
8. Disadvantage: When you sign a lease agreement, the seller obligates themselves to sell the home in the future for a predetermined price. If the price of the home increases in value over the life of the lease option, the buyer benefits from the value increase provided they choose to exercise their lease option.
In summary, we have discussed numerous advantages and disadvantages to offering a lease option. Ultimately, it depends on your situation. If your mortgage payment is too much of a burden for you and you need to sell fast, offering a lease option will bring more buyers offering a larger selling price. You must also look at your personality. If you do not feel comfortable with another person using a home that you are ultimately responsible for, a lease may not be good. However, if you are comfortable with other people living in the home, have a decent interest rate on your current mortgage, and are investment oriented, a lease option may be just right for you as the passive income can range from 20% to 100% of your invested equity per annum. A handsome return for a low risk investment.