Buying with a lease option and an FHA mortgage

by Gina Pogol
November 20th, 2010

Housing prices may have hit bottom in many markets; in some parts of the country they have begun increasing. You’d love to be able to take advantage of this but the same economy that blasted property values took its toll on you as well. Those with damaged credit or a gap in employment probably need some extra time to stabilize their finances and rebuild their good credit before they can realistically expect to get approved for a mortgage.

FHA does allow you to buy with a lease option

If you think real estate prices in your area have bottomed out, you might find a lease option or rent-to-own arrangement to be a good investment. To buy a home with an FHA mortgage, you’ll need at least 3.5% down but 10% down might allow you to be approved with a poorer credit score. FHA allows you to include in your down payment any payments that exceed what an appraiser counts as fair market rent.

How are these arrangements structured?

A lease option is different from a rent-to-own arrangement. Lease options typically involve a non-refundable payment made upfront for the privilege of purchasing the property at a later date for a predetermined price. If you fail to adhere to the terms of your lease (for example if you don’t make your monthly payments on time), you lose your deposit. A rent-to-own arrangement involves paying rent plus a premium each month for an agreed-on period of time; when that period is up, the tenant has the option of buying the home and the excess rent is applied to the down payment. Many agreements combine both arrangements, with both an upfront payment and extra rent payments.

What does FHA require?

To get full credit for extra amounts paid toward your down payment when you apply for your FHA mortgage, your lease agreement must specify which amounts are normal rent, which are extra payments, which are ordinary deposits, and which fees are option payments which will be credit toward your down payment. Keep in mind that just because your agreement says a certain amount will be credited toward your down payment, your lender doesn’t have to credit you with that amount. For example, if market rents in your area are $1,000  a month and you pay $1,200, it doesn’t matter that your agreement says that $400 a month will be credited toward your down payment — you’ll get credit for $200, because that is what the “real” excess rent is. The additional credit would be considered an “inducement to purchase” and not a legitimate down payment. In addition, you will have to be able to prove that you made these payments on time, so keeping copies of your canceled checks is a good idea.

Lease option pitfalls

It’s best to have a real estate lawyer look at any lease option or rent-to-own arrangement before you sign it.  Some sellers structure their agreements so that it is virtually impossible to exercise them; they sell the property over and over,  keeping option fee after option fee.  In addition, get an appraisal or at least a broker’s price opinion (BPO) to make sure that the sales price is a fair one. Finally, understand the risk that if home values continue to drop, you are locked in to purchasing at a higher value or losing your option fee (the flip side is that if values rise, you get to buy for less).

Lease options can help buyers and sellers, but there is a right way and a wrong way to structure them if you want a mortgage,

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