Friday, October 22, 2004

Lease To Own One of Several Bad Credit Options

For many buyers without cash or with credit problems, the solution to homeownership in the past 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 time period, usually paying a rent higher than market rate. The extra cash is then applied to an agreed upon down payment amount. In the end, once the down payment is acquired (and hopefully a better credit rating for the buyer with time), the transaction is consummated with a settlement and the property exchanges hands.

I’ve received numerous letters from readers asking 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 the 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 an additional 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 s/he can afford to set aside. To attain $10,000 would require an additional $833 per month for a year; $555 per month for 18 months; or $416 per month for 24 months.

Thus if the going rent for this house is $1,200, the premium would be tacked on to the rent and set aside for the down payment so that with the one-year plan above, the monthly payment would be $2,033.

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

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 – thus giving you a home not worth the amount you agreed to in the past. 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 in value, the house would then be worth only $194,000. The eventual lender may require a 5 percent down payment -- from this new level of value – meaning the maximum loan amount is $184,300.

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

The opposite is also true – and is a risk the seller takes in this scenario. 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. On this side of the transaction, it’s a much easier scenario -- the seller just lost six grand. He doesn’t actually have to write a check, it’s lost mainly 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 a purchase option agreement instead of the lease to purchase agreement. This means the house does not have to settle – it just 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 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 date 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 final word of caution: don’t try this on your own. A lease-to-own arrangement can get a lot sticker than a traditional transaction because there’s now a legal arrangement for a prolonged period of time 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 out professional help to make sure everything is on the up and up.

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