The differences between rent-to-own and installment land contract agreements are subtle, but distinct.
The differences between rent-to-own and installment land contract agreements are subtle, but distinct. Each contract has its pluses and minuses, and buyers need to be particularly cautious. Both sellers and buyers should treat the deal as a sale rather than a lease, including purchasing an independent appraisal and thorough inspection. Sellers should insist that buyers complete a rigorous application and submit to a credit check. Both should hire expert legal representation.
Lease Options, Lease Purchases or Rent-to-own
Renting to own, also known as "lease option" or "lease purchase," offers both buyers and sellers a good opportunity. Buyers, if they've found a home they love, can slowly build a down payment and get a taste of pride of ownership. Sellers can earn income and move a home in a difficult market while also commanding a top price. The arrangement seems ideal. There are important considerations, however. Buyers must remember that their rent payments, although applied toward a future down payment, are not earning equity. Sellers may learn the hard way that buyers are never able to consummate a purchase. Both sides must hope that the price of the home doesn't appreciate or depreciate so much during the course of the lease that neither side wants to complete a sale.
Lease Purchase Deal Terms
To successfully begin a lease purchase deal, the seller and tenant must agree on a purchase price, even though the sale won't be completed until the end of the term, which usually lasts two to five years. The tenant pays an option consideration fee at the beginning of the lease that's equal to 1 percent to 5 percent of the purchase price. This fee is applied toward the down payment of the home, but does not constitute equity; the tenant, if he is unable to get a mortgage, forfeits the option fee. Tenants also pay above-market rent, known as rent premium. All or a portion of this premium is applied toward the down payment, but like the option fee, is nonrefundable in the event the sale is never completed.
These points make renting-to-own a risky proposition for potential buyers. During the course of the lease term, tenants should take active steps to improve credit while also saving extra funds toward a down payment. Tenants should also check with a reputable mortgage broker to determine if mortgage lenders will consider rent premium and option fee payments as a down payment. Sellers should determine if offering the home as a "rent-to-own" triggers a mortgage clause that forces payment in full.
Installment Land Contracts, Land Contracts or Contract for Deed
Land contract deals, also known as "contract for deed," offer more protection for buyers but are also more costly. However, transactions are recorded as "sales" and buyers do have equity in the home. Sellers earn monthly payments that include interest, while also continuing to hold the deed as collateral -- hence, "contract for deed." Buyers pay all maintenance expenses along with property taxes and insurance, and if the deed holder needs to sell the home in an emergency, buyers are entitled to a refund of all monthly payments, money the seller earns when the home is sold.
Buyers probably won't be able to take out a home equity loan against the property, but they may be able to take a tax deduction, depending upon other factors, such as income. They also pay an up-front fee that's equal to 1 percent to 10 percent of the sale price, also refundable in the event the home is sold by the deed holder.
Contract for Deed Pros and Cons
Buyers assume huge benefits, but must be absolutely sure to improve their credit scores enough over the course of the deal term so they'll be able to refinance to a traditional mortgage. If the deed holder is forced to sell and the buyer cannot secure a home loan, he'll be forced to move.
Sellers benefit because they can command a top price for the home while also earning monthly income. However, they must be certain that they can afford to maintain multiple homes in the event the buyer defaults. Although sellers have the right to foreclose, it may take several months before eviction takes place.
Buyers and sellers would be wise to complete a thorough due diligence process to ensure clear title and credit histories, as well as address affordability issues. Hiring experienced legal counsel should help accomplish these goals, critical to the success of any deal.
