What Is a Lease Option?

A lease option is an agreement that gives a renter a choice to purchase the rented property during or at the end of the rental period. It also precludes the owner from offering the property for sale to anyone else. When the term expires, the renter must either exercise the option or forfeit it. A lease option is also known as a lease with the option to purchase.

How a Lease Option Works

A lease option gives a potential buyer more flexibility than a standard lease-purchase agreement, which requires the renter to buy the home when the lease ends. The price of the home is agreed to upfront by the buyer (the renter) and the owner. The price is typically at the current market value of the home, allowing the renter to buy the home in the future at today's price. For that option, the renter is usually charged an upfront fee by the owner, which might be 1% of the home's sale price. The fee goes to the downpayment if the renter decides to buy the home at the end of the lease.

The lease option is especially helpful to those who might be building their credit or don't have enough saved for a downpayment. However, there are several features of lease options to consider.

Rental Payments

The owner charges a premium in addition to the standard monthly rent for the option to buy at today's price when the lease ends. The premium might be a percentage added to the current -market rent such as 10% of the standard monthly rental amount for a home of that size. The extra amount or premium, which is often called rent credit, becomes part of the downpayment for the home if the option is exercised to buy the home by the renter. However, the renter forfeits the extra money paid above the standard rent if the home is not purchased at the end of the lease.

Some owners might take a one-time cash payment, often called "valuable consideration," which is similar to the premium paid for an option in the financial markets. It is not a deposit on the purchase of the property, meaning it's not refundable. The amount ranges from a token $100 to 5% of the expected purchase price.

Bank Financing with a Lease Option

The good news for renters is that typically, banks will allow the total funds of the premium above the rental payments to go to the downpayment for purchasing the home. However, if the rent charged was an at-market rate, the bank may not allow any of the funds to be applied to the purchase price. It's important that buyers check with multiple banks to determine their policies regarding financing a mortgage for a home with a lease option.

The Term of a Lease Option

The term of the option may be any period on which the property owner and renter agree, but is commonly one to three years. The lease option contract also stipulates the property's purchase price at the start of the lease or how that price will be determined at the end of the option.

Key Takeaways

  • A lease option is an agreement that gives a renter a choice to purchase the rented property during or at the end of the rental period.
  • A lease option also precludes the owner from offering the property for sale to anyone else.
  • A renter usually pays some percentage above the standard monthly rental amount, which goes to the downpayment for buying the home.

Reasons to Use a Lease Option

There are several reasons why the renter and the owner might enter into a lease option. It's important to consider whether the benefits outweigh any drawbacks for entering into the agreement.

Why Renters Enter into a Lease Option

A potential buyer may have many reasons to use a lease option rather than buy the property outright at the start. A major consideration is not having enough money or credit to make the purchase. Renting can allow the potential buyer to save money for the purchase and at the same time, build their credit by making regular, on-time payments.

The renter has a chance to buy a property in the future at today's prices. If the renter doesn't have the money saved today to buy the home but is worried the home's value will increase in the next few years, the lease option is a good choice. Also, if the renter loves the home, the school district, or neighborhood, the lease option takes the home off the market—allowing the renter to save enough to buy it when the lease ends.

Even if the potential buyer has the means to purchase the property, they may not want to commit to it right away. For example, if the potential buyer is from another place, they might want to live in the new town before committing to the purchase. Or, they may still have their old property to sell before being able to buy the new property.

Finally, the property may not qualify for certain loans, including a VA loan, due to needed repairs or upgrades. By renting first, the potential buyer can make those improvements in order to qualify for the loan later.

Why Owners Enter into a Lease Option

A property owner may enter into a lease option agreement because they had trouble selling the house outright. The option can make the property more attractive to different types of potential buyers.

Also, if a homeowner is thinking of selling the home in a few years, the lease option allows the owner to collect a premium above the current market for rent. The worst-case scenario is that the renter doesn't buy the house; the owner places it on the market to sell and keeps the extra funds paid above the standard monthly rent.

There may also be tax issues involved in selling the property outright now instead of selling it later. The option, while not a guarantee to sell later, does make it more likely that the owner has a buyer ready to go at the end of the option.

The renter forfeits the extra money paid above the standard monthly rent if the option to buy the home is not exercised at the end of the lease.

Special Considerations with Lease Options

Renter's insurance is typically required for the renter's personal belongings. Renter's insurance protects for any loss in value of belongings and furnishings in the home. Also, it's important that it be mandated that the owner also have homeowner's insurance in the event something happens during the lease term that could adversely affect the property's value such as a fire or water damage.

An appraisal contingency should be included in the lease option agreement. In other words, when the lease ends, the home's value could have decreased. An appraisal provides an updated value of the property before the purchase and sale goes through.

It's important to calculate the exact amount of money that's to be paid to the owner at the end of the lease option. Remember, the owner is taking the house off the market and forgoing any gains in the home's market value by entering into the lease option. The owner will want to be adequately compensated for not being able to sell the house to another person who was ready to buy it.

For those considering a lease option or a lease option to buy, they should ideally have a lawyer who is familiar with lease-option transactions to review the fine print to make sure there aren't any surprises when the lease term ends.