Q: Hi Robert, I am looking to rent a home in the Willow Glen neighborhood of San Jose, CA. On Zillow and Trulia, where I search for homes, I see homes listed for rent that are lower in monthly payments than others in the same area. The descriptions say, “Take over payments, rent for six months to two years and get the deed in your name.” Are these rent-to-own homes legit?
– Carolina, San Jose, CA
A: Carolina, you are probably referring to a “lease with the option to buy” or simply, “lease option.” It is one of a host of home-buying alternatives sellers are offering as an opportunity for those who can’t get a home loan because they have credit problems or don’t otherwise meet underwriting guidelines.
These alternatives can open the door to homeownership, but they can also be risky ventures that set you back.
Let’s take a look at your options.
Lease option – The best lease options benefit both the seller and the buyer. The seller typically wants to keep up on mortgage payments until the home appreciates sufficiently and can be sold for a profit or break even amount. The buyer is often cash-rich but savings-poor and wants a alternative way to put a roof over his or her head.
The seller and buyer contract to allow the buyer to move in and lease the property for a predetermined rent, term and selling price. At the end of the term, the buyer can exercise the option to buy the property — or not. Typically, a small portion of the rent goes toward the down-payment and/or closing costs, the larger amount continues to help pay the sellers’ mortgage.
If the buyer decides not to or can’t exercise the option to buy, all monies paid to the owner — including the amounts set aside for the down payment — are forfeited to the seller. Much must be negotiated upfront so that there are no misunderstandings.
Setting the price today for a sale in the future can be tricky. The price should be comparable with or lower than what the buyer would expect to pay for a similar home at the time he or she is ready to exercise the option to buy. At the same time, the seller doesn’t want to take a loss and will likely want to set the price as high as possible.
Locking in any price today, in a market that could experience another dip in real estate prices, could leave the buyer with the short end of the deal. Home prices today may not appreciate much if at all in the next few years. You may instead want to wait a little longer, clean up your credit, save money and put yourself in a position to buy outright in a few years.
If prices do rise, the seller may lose some profit and the buyer will win, but either way, its a gamble.
Land Contract of Sale – In this transaction, the seller retains title but records the contract so that the parties cannot sell the property without the buyer’s consent. The buyer usually makes the payments directly to the seller and the seller, in turn, makes the payment to the lender if there is still an outstanding loan or loan(s) on the property.
Subject To – This may be one of the easiest alternatives, but it is not necessarily the best alternative. With this type of transaction, a property owner transfers title to the new buyer and records the change with the county recorder’s office for minor transfer costs. After the transfer, property rights belong to the buyer. Keep in mind, the existing lender or lenders also have a claim on the property.
As a buyer, taking title “subject to” can also mean you are assuming a bad debt if the property is worth a lot less then the mortgage amount. You’ll also assume any delinquent tax bills and other liens on the property.
There are also dangers for the seller. Even though the seller transferred the title, the seller remains liable for the mortgage. If the buyer misses a payment, the lender won’t go after the title holder. The lender will go after the seller and the seller’s credit report will suffer. If the title holder misses payments throughout the life of the loan, that’s how long the seller’s credit will suffer.
Loan Assumption – With a loan assumption, the buyer assumes the loan and the seller is usually relieved of his or her liability to the lender for the remaining balance because there is now a new buyer/owner on the loan.
Be aware, loans typically have a “due on sale clause” or “acceleration clause” that allows the lender to make the loan immediately due in full if the seller transfers the title without the lender’s consent. A transfer without the lender’s consent could trigger a foreclosure.
And not all loans are assumable. Federal Housing Administration (FHA), Veterans Administration loans, and a few adjustable rate mortgages (ARMs) are, but you typically can’t assume any of them without qualifying for the mortgage, just as you would apply for a mortgage the conventional way.
Sellers should avoid both “subject to” and mortgage assumption alternatives unless the buyer can fully qualify for the existing mortgage and guarantee you in writing that you will be relieved of any future liability on the mortgage.
Bottom line
In today’s market, buyers shouldn’t consider these alternatives if the seller is “underwater” — holding a mortgage that is greater than the home’s value.
If the mortgage is equal to or less than the value of the home, a lease option or land contract could be good options.
However, buyers are better off renting until they are fully qualified to buy their own home at current or near future prices and interest rates.
Little price and interest rate movement is expected in the near future. There’s no need to rush into a home using potentially risky alternatives.
