Thursday, October 28, 2004

For many buyers without cash or with credit problems, one solution to homeownership has been a lease-to-own contract. The traditional wisdom behind this arrangement has been that the buyer is able to rent the property from an owner for a designated period, usually paying a rent higher than market rate.

The extra cash is then applied to an agreed-upon down payment. In the end, once the down payment is acquired — along with a better credit rating for the buyer, one hopes — the transaction is consummated with a settlement and the property changes hands.

Numerous readers have written to ask how this arrangement works. It depends on the wants and needs of both the buyer and the seller.

If a buyer needs cash for the down payment, then lease-to-own is a possibility.

Here’s how it works. To build up a 5 percent down payment for a $200,000 purchase, the lease agreement would include rent, plus a premium on the rent that will be used to build up the down payment. The amount of the premium depends on how much the buyer-renter wants to save and how much he can afford to set aside.

To attain $10,000, it would require an additional $833 per month for a year, $556 per month for 18 months, or $417 per month for 24 months.

Thus, if the going rent for this house were $1,200, the premium would be tacked onto the rent and set aside for the down payment. In the one-year plan, the monthly payment would be $2,033.

What this does for the buyer is guarantee the purchase of a house at today’s prices — assuming he wants today’s prices. In a market that is dropping in value, a lease-to-own could set one up to buy a house at today’s prices only to find that when he finally settles on the property, it’s actually worth less than it was on the day he agreed to buy it. The seller, on the other hand, may be cutting off future gain if a property is moving upward.

In a dropping-value scenario, the buyer may have a difficult time getting the desired financing in the future if the price of the house drops too rapidly. You could still buy it, but you may have to come up with even more cash to satisfy the eventual lender’s loan-to-value limits.

For instance, if you agree to $200,000 and in a year it drops 3 percent — $6,000 — in value, the house would then be worth only $194,000.

The eventual lender may require a 5 percent down payment — $9,700 — from this new level of value, making the maximum loan amount $184,300.

But since you agreed to buy the house for $200,000 and were planning on a mortgage of $190,000, you’re now short $5,700. This is the difference between what you were planning on borrowing — $190,000 — and what the lender will now let you borrow, $184,300. Because you’ve already agreed to pay $200,000, you must come up with the $5,700 or be in breach of contract.

In times of rising values, the seller takes the risk. What if the house increases in value the same amount — 3 percent? That means that in a year, the house would be worth $206,000 instead of the agreed-upon sales price of $200,000. The seller doesn’t actually have to write a check; it’s lost on paper. Because of the contract, he can’t demand the extra money.

If the seller wants to take a gamble on increasing values, he could write up a lease-with-purchase-option agreement instead of the lease-to-purchase agreement.

This gives the renter the option of buying the house at either the fair market value at the end of the lease or an agreed-upon sales price that might be higher than today’s going rate.

As far as the paperwork goes, a contract is written up with the agreed-upon sales price, but the settlement is set for a year later — with the contingency that the buyer will rent the property for that amount of time.

Simultaneously, the renter-buyer and landlord-seller sign a lease contract establishing the monthly rent, due date and what the two parties will be responsible for over the rental period. At the end of the lease, the house goes to settlement and the renters become the new owners of the property.

One closing caution: Don’t try this on your own.

A lease-to-own arrangement can get a lot stickier than a traditional transaction because there’s now a legal arrangement for a prolonged period between the buyer and seller instead of the usual shorter term. Plus, the seller is now agreeing to be a landlord, which comes with its own set of rules and regulations. Time breeds discontent, especially if the price starts to fluctuate.

Seek professional help to make sure everything is on the up and up.

M. Anthony Carr is the author of “Real Estate Investing Made Simple.” Post questions or comments to his Web log (

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