“I am attracted by the idea of buying a house under a lease-to-own plan, but am frightened by reports of scams. Should I be?”
Frightened, no; careful, yes.
Any kind of financial contract can be structured in such a way that all the benefits flow to one of the parties and none to the other. Lease-to-own (LTO) plans are hardly unique in that regard. But LTO plans have a solid economic rationale, which means that they can be structured so that both parties benefit.
LTO Contract Features: An LTO is a lease combined with an option to purchase the property within a specified period, usually three years or less, at an agreed-upon price. The borrower pays an option fee, 1 percent to 5 percent of the price, which is credited to the purchase price. The borrower pays rent and an additional rent premium that is also credited to the purchase price. If the purchase option is not exercised, the buyer loses both the option fee and the rent premium.
An LTO deal thus has five major provisions. The sale price of the house and the rent are market-determined, yet subject to negotiation just as in a straight purchase or rental transaction. Buyers often know less about the market than sellers, which places buyers at a disadvantage unless they do some homework, which is advisable.
Buyers generally prefer a long option period because it provides more time to build equity and repair credit. A long period can boomerang on them, however, if they are never able to exercise the option, since they lose the rent premium they have been paying all the while, in addition to the option fee. Sellers generally prefer a short option period, but if it is too short, the house won’t be sold.
The option fee and rent premium are viewed differently by buyers and sellers. To the buyer, they are part of the equity in the house they will soon own. Fully anticipating that they will exercise the option, the only cost is the interest they would otherwise have earned. To sellers, however, these payments are the best guarantee that their houses will sell; if they don’t sell, the payments are retained as income. That the benefit to the seller generally exceeds the cost to the buyer makes the lease-to-own deal a possible win-win.
Using an LTO to Buy: LTOs offer home-ownership opportunities to consumers with little cash and/or poor credit, who are prepared to bet on themselves. The bet is that before the option period expires, they will qualify for the mortgage they need to exercise the purchase option. During the option period, they have the opportunity to rebuild their credit and accumulate equity while living in the house.
The development of the sub-prime market, in which consumers with poor credit or no cash can obtain loans, does not seem to have lessened interest in LTOs. It is very likely that those who succeed in exercising their option under an LTO do better than if they had financed a conventional purchase in the sub-prime market. The savings in finance costs will more than offset a higher price on the house. But those who can’t exercise their option will lose their bets.
Consumers who need to rebuild their credit rating during the option period should understand that paying their LTO rent on time won’t do it. Rent payment information is not used in compiling credit scores. While Fair Isaac, the company that developed credit scoring, has recently unveiled an “expansion” score based on “non-traditional credit data,” it does not yet include rent payment information from individual homeowners. LTO buyers who need a higher credit score must focus on their credit cards and loans.
Even though it is costly, the right not to exercise the option is of value to buyers. If there is something seriously wrong with the house, neighborhood, or neighbors, the money left behind on an LTO is much smaller than the cost of an outright purchase followed by a sale.
Using an LTO to Sell: Most home sellers want a cash sale, but for those prepared to hang on to the property awhile longer, the benefits can be compelling. Bob Bruss, an expert’s expert on LTOs, says that there are always more LTO buyers than sellers – he has been both. As a result, buyers generally pay top dollar, perhaps including some assumed future appreciation.
To be sure, the deal may fall through, but in that case the seller gets to pocket the option fee and rent premium. The seller also enjoys the tax deduction on his mortgage interest payments during the option period.
The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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