Rent Now, Buy House Later

If you can't qualify for a mortgage, you might consider another path to home ownership: renting a house now with the option to buy later. During this lease-option period, you could save for a down payment and repair credit problems that currently block your mortgage eligibility.

"You also can build up option credits toward the purchase," says Wendy Patton, a real estate agent in Clarkston, Mich., and author of "Rent-to-Buy: Your Hands-on Guide to Buy Your Home When Mortgage Lending Is Tight."

How a lease option works

Say the house would sell for $100,000, and your monthly rent is $800. "You could work out an arrangement with the seller," Patton explains, "so that the $800, or a good portion of it, gets applied every month toward the purchase price. You'll build equity in that home before you even purchase it."

You can set up a lease-option arrangement in various ways. You might apply all or a fraction of your rent toward the purchase price. You also might pay the seller a lump sum up front, called an option fee. Patton recommends paying an option fee of no more than 1% of the purchase price, to be held in escrow until the closing, if the seller agrees. That way, if the seller reneges, you'd get the fee back�but not if you're the one who bails on the deal. For example, will this still be the house you want, even if your family situation changes?

The option period usually will be no longer than three years. But you could ask for more time. In a lease option, Patton points out, "Everything is negotiable: the sales price, the rent, the amount applied toward the purchase, the option period�everything."

In most lease options, however, the rent credits and any option fee you paid will be nonrefundable if you decide not to buy the house. You could lose everything you've invested. That's why you need to know what you're getting into and take steps to minimize the risks.

Check out the seller

One risk is that the seller might have financial woes that could make your lease option worthless down the line. Say the seller still has a mortgage on the house and falls on hard times. The seller could pocket your rent checks every month, but make no payments to the lender holding the mortgage. The lender then could foreclose and, as the tenant, you'd face eviction and lose what you've paid toward buying the house.

If the seller has a mortgage, Patton advises asking the seller to sign a mortgage authorization form, which permits you to contact the lender to get information about the loan. Are payments current? Does the seller owe more on the mortgage than the house is worth on the market�a situation referred to as being "under water" or "upside down"?

"As a buyer, you want to make sure the seller is not in foreclosure or upside down," Patton stresses. "I wouldn't touch either with a 10-foot pole. There's too much risk."

Even if the seller is current on the mortgage now, that could change and, again, you could lose what you've invested. Patton recommends setting up the deal so you write your rent check to the seller's lender, not to the seller.

Before entering into a lease option, learn all you can about the seller. Get a credit report. Ask about reasons for selling. Is it due to a job loss or promotion? If the seller is moving because of buying a new home, is it a move up or down? The answers give clues to the seller's financial situation.

More smart moves

Like a sales contract, a rent-to-own contract triggers disclosure requirements for the seller in some states, says Janet Portman, a real estate attorney, author, and managing editor at Nolo, a publisher of do-it-yourself legal books and software in Berkeley, Calif. The disclosures cover the sorts of things you'd want to know if you were buying the house, such as the age of the roof and the presence of lead paint.

"You also need to get a professional inspection of the house," Portman says, "just as you would if you were buying." Negotiate with the seller about who will pay for home repairs and maintenance during the rental period.

One of Portman's key cautions in fashioning the lease option is to include a way to determine the ultimate selling price for the house. You could set a price up front, although neither you nor the seller may want to do that if the sale won't occur for a couple of years.

But avoid vague wording that says you'll rent with the option to buy in two years at market value. "That is the most typical and disastrous way to phrase this," Portman says. "It doesn't set a way to ascertain market value so that no one could argue about it."

A solution is to stipulate in your contract that, at the time of sale, the buyer and seller each will pick a broker and those two will determine the sales price. "You also need to state that if the two brokers disagree," Portman notes, "they will choose a third party whose decision will be final."

Another matter to set straight at the beginning is how you'll notify the seller when you want to exercise your option to buy. The lease-option contract should spell out a clear expectation, such as: "The buyer will provide written notice to the owner by midnight, May 31, 2013."

"That will avoid arguments about whether you properly exercised the option to buy," Portman says, which could sink the deal.

Indeed, everything in the lease-option agreement should be in writing. This article covers just a few points to consider in these complex deals. State and local laws vary considerably. Legal help is essential, Portman and Patton advise. Find an attorney who has experience with lease-option arrangements; not all real estate attorneys are familiar with them.

Be sure, too, that you'll be ready to buy by the time the lease option expires. Will you qualify for a mortgage? Will you be able to afford all the costs of home ownership, beyond just mortgage payments? Your credit union lender can help you devise a plan so that, when the time comes, you'll be able to answer yes on both counts.

Published March 18, 2010