The Advantages and Disadvantages of Buying a Lease Option

Buying a home can be a satisfying or frustrating experience depending how financially ready you are to own a home. Buying a home can be very expensive with the major expense of purchasing a home being the down payment and mortgage fees. These costs are intended to pay the fees necessary to get the mortgage setup and generate some equity in the home to hedge the risk the bank is taking. In years past, this down payment could be very small, but with the fall of the housing market in 2006, those days are long gone, making it prohibitively expensive to buy a home. When there are fewer buyers and less credit around, sellers begin to offer other ways to sell their home. The “Lease Option” is one such method. A Lease Option is technically a lease (rental) with the option to purchase. You are renting the home but have the right to purchase the home at anytime during the rental period at a pre-determined price.

A lease option can be a very favorable way to purchase a home because it provides the advantages of home ownership without the disadvantages of ownership. The main advantages include: (1) No mortgage fees (2) less for a down payment (3) limited risk if the value of the home falls but you profit as the home appreciates. When structured property, there really are no disadvantages to a lease option relative to purchasing the home with a mortgage. When compared with renting, the major disadvantages of a lease option include: (1) pay more money upfront than renting (2) you are responsible for repairs, not the landlord. Each advantage and disadvantage is discussed in greater detail below.

1. Advantage: No mortgage fees. Because a lease option is technically a rental, the agreement is between you and the seller. Because the bank is not involved, there are no bank fees, meaning that you don’t have to come up with the $5000 to $9000 that it costs to get a mortgage. However, eventually you will have to get a mortgage if you decide to stay in the home long term.

2. Advantage: Less for a down payment. Like the mortgage fees, because the agreement is between you and the seller, the money down is negotiable, and sometimes not required at all, though the amount down typically ranges between $5000 and $10000 dollars. This is still better than the bank will require.

3. Advantage: Limited risk and leveraged returns. A lease option is an option to purchase, not an obligation to purchase. This means that when the lease term expires, if the home has lost value, you can choose to walk away. You give up your down payment, but are not saddled with a home that cannot be sold. However, at the same time, if the home increases in value, because the purchase price is set, you can purchase the home for less than it is worth on the open market. This key element makes lease option homes potentially a great investment, because you can leverage your money with such little risk. For example. If you purchase a $300,000 home with a mortgage, you would need to bring about $20,000 at closing ($15,000 as a 5% down payment and $5000 to cover mortgage fees). If the home’s value increased 5% over two years, the home would be worth $315,000. Your $20,000 turned into $30,000 ($15,000 in equity to start + $15,000 in appreciation); a 50% return on your money over 2 years. However, if the home decreased 5% in value, the home would be worth $285,000, and your $20,000 investment turned into $0.00. However, if the same home was bought as a lease option, then $5000 down would turn into $20,000 ($5000 in equity to start + $15,000 in appreciation); a 400% return on your money over 2 years. If the home decreased 5% in value, the home would be worth $285,000 but you can walk away having only paid the upfront down payment of $5000. In this example, the lease option reduced potential profits by 75% and increased potential returns by 350%.

5. Disadvantage: Pay more money upfront. Typically a lease option requires a greater amount of money upfront than renting. This is not always the case and depends on how desperate the seller is the lease the home. Generally you can expect to pay twice what you normally would put as a deposit on a comparable rental.

6. Disadvantage: Responsible for repairs. One nice thing about renting is that the landlord is responsible for repairs. In a typical lease option, you are entirely responsible for maintenance of a home.

There are both advantages and disadvantages to buying a lease option. When compared with the buying the home with a mortgage, there is really no disadvantage and when compared with renting, a lease option is a relative low risk investment for little additional out of pocket expense. The key, however, is in the terms of the agreement between you and the landlord. The terms are negotiable, so make sure you do so. To summarize, a lease option can be a win/win situation for both buyer and seller. If you are looking for a home but don’t have enough for a regular down payment or are not sure if the market is going to get worse before better, consider a lease option and rest easy.