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Jim Simms' Blog

By Jim Simms | Mortgage Broker
or Lender in Louisville, KY

Rent to Own (continued)

In the last blog entry we touched on the reasons behind Rent to Own or Lease Option Transactions.  In this segment we will take a look at the subject for a lender’s point of view.  Any transaction that falls into one of these categories is going to be reviewed with a little more skepticism from the very start.  Not because there are not valid reasons for the use of a lease/purchase, it is because most buyers seek such a transaction because they have some obstacle keeping them from securing financing through normal channels.  It is like a signal from the buyer that I have been rejected for financing so I did this instead.

 

Is this bad?  No, just saying it starts out with a raised eyebrow from the beginning.  What underwriter or loan officer wouldn’t question why the lease option, at least in their own mind.  Human nature is going to cause us to question, why did you do that?  Is the industry instructed by underwriting guidelines to ask this question, nope.  I am just sharing that we are people also and will question weird stuff just like anyone that isn’t working in the industry. 

 

Buyers and sellers are under a misconception that they are the only parties that matter when negotiating a contract, any purchase contract, not just lease options.  Not true if either of the parties are using traditional financing to make the deal work.  Example, if the buyer is trying to do a lease option until they correct some credit issues or waiting for some time period to pass so they will be eligible for financing, then the lender will also touch the lease option.  Especially true if the buyer is going to receive some credit for money paid during the lease agreement.

 

Credits

 

Credits under a lease option or rent to own usually fall in one of two categories, 1) money paid upfront as a deposit or option consideration  2) a portion of the rent.

 

I have seen some very poorly written lease options over the years.  The buyers and sellers usually allocate more of the rent towards down payment than underwriting guidelines allow.   This can be a disaster for the buyer if they believe they are making a down payment to the seller over time only to have it denied by an underwriter once they apply for permanent financing. 

 

Okay, this gets strange, hang in there and we will sort it out.  Let’s say a buyer and seller write up a lease option and nothing extra is paid for the option part of the contract.  However, they establish the rent will be $1,000 a month with all of the rent for the first year to be applied to the purchase price once the buyer exercised the option to purchase.  Let’s assume the option to purchase is for a year at a price of $120,000.  The buyer assumes they are going to have a 10% down payment in the form of a credit when they apply for permanent financing.  Not the case!! 

 

The mortgage underwriter can reduce the sale price from $120,000 to $108,000, but not recognize any of the $12,000 reduction as a down payment.  It may be a credit towards the purchase price, but will not meet the definition of a down payment for obtaining a loan.  Rent is rent and down payments are down payments, not the same things.  If the market rent of the property was only $600 a month then the extra $400 could be used towards down payment.  It is easy to see how this can mess up the plan.  The buyer thought they were going to have a $12,000 down payment when only $4,800 qualified.  

 

Here’s the weird part, according to the contract $12,000 gets knocked off the purchase price of $120,000 leaving $108,000 to be financed.   After the underwriter adjusts the transaction to meet guidelines, the sale price is $112,800 with only $4,800 going towards down payment and still leaving $108,000 to be financed.  The buyer expected the down payment to be 10% of the purchase price but the underwriter only accepted 4.25%. 

 

You might wonder why does it matter?  The buyer still only needs to borrow $108,000 under either scenario.  It could be a deal killer and the buyer could lose all of the money they paid in rent expecting it to be a down payment.  If the market rent should have been $1,000 a month none of the rent can be used to qualify as a down payment for a loan therefore the loan application would be denied.

 

Who determines what the market rent is for the home?  The appraiser that does the appraisal for the lender.  The only way to be safe is to document the market rent on the front end by having an appraisal that specifically calculates the market rent.  Something I have never seen done in advance.

 

An easy fix, don’t allocate any of the rent to the purchase price, only the amount of money paid upfront for the option consideration or deposit.  That does not raise a red flag and cause the underwriter to re-cast the transaction.   

Comments

By John King, GRI, SFR, Broker,  Fri Dec 30 2011, 11:42
Jim,
Nicely said, great examples!
--John
By Jim Simms,  Fri Dec 30 2011, 12:08
Thanks John, I hate seeing honest people getting ripped off.

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