June Lizotte pretty much covered what a lease-option is although there may be some cross-over definition of a 'first right of refusal' in her paragraph, but it's largely accurate. As anything is in real estate, it's negotiable. Here is a bullet point list of some hard line rules to consider when negotiating a lease/option:
1. You lease a property at a given rate considered rent, call it $1,000/month for sake of conversation. That lease will likely be a minimum of 1 year. This is a market rent for the property. No portion of the market rent is credited to a to-be-determined purchase price. You are basically 'renting' and this you understand.
2. You purchase an option to buy the same house with a price to be determined at some point in the future, typically by the exercise date of the option. This may or may not work in your favor as the market may change. IE: the market value of the property may increase (not in your favor), or decrease (in your favor). If the market declines and you exercise your option, the seller may be miffed. If the market increases and you exercise your option, you are paying a higher price then when you first negotiated the option to purchase.
3. The price of the option, call it $500 for sake of conversation, may or may not be credited to the price of the house. Also, this option to purchase may or may not be transferable to another party, and if it was transferable it typically must meet the approval of the seller. Keep the option price as low as possible to reduce your risk of loss should you choose to not exercise the option.
4. All the while you lease this home, you must still save up for a down payment. Sometimes, you can pay a premium above rent and let it accrue in escrow if you can find an escrow company to service the transaction. If you are under contract to pay $1,000/month rent, try and afford $1,200/month so that residual $200/month may accrue over a period of time before you exercise the option. This allows you to show any lender that you have some form of downpayment. You can also add to the escrow account like a bank account such that these monies continually grow like savings. You may also select an interest bearing account to gain interest over this time. Provision in your option that residual monies above market rent are refundable to you should you choose to not exercise the option. The seller has a right to collect only the monthly rent and option price at the inception of the agreement.
5. I strongly encourage an escrow company to work as a collection agency that pays an existing lien holder, as some sellers may choose to not pay the debt service which may initiate a short sale or foreclosure. I have seen this happen. Make sure you record the option to purchase, so your interests are protected to some extent should such a situation arise. It is not necessary to record a lease contract though, just the option to purchase. An attorney can provide this recording service along with the contract itself.
However, any lien holder may 'call the note' if they catch wind of a lease/option to purchase contract on their loan which is secured by the property (collateral) such that the home owner (seller/landlord) must suddenly satisfy the note. This could be untimely. As long as the debt service is consistently made, the risk may be low for this. Obviously, a property that is free and clear of any debt is the best candidate for a lease/option to purchase such that the risk of any lien holder closing-in is eliminated.
6. Hire a real estate broker to identify a lease-option candidate property. AND, most importantly, have an attorney prepare the lease option contract. I have seen many brokers miss the target on this. I myself have learned from a lease/option experience.
Points to remember:
1) Low option price.
2) 2-3 year exercise date, longer if the seller will agree (keep in mind they typically want to sell now).
3) Option that is transferable.
4) Record the option.
5) Hire an attorney, it's worth the $600 to $800 they will charge you and it's done correctly.
6) Identify an escrow company to service the lease/option. They will charge a fee, but your interests are further protected.
Good luck and be careful!
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