The skinny on lease-to-own home sales

A lease-to-own house purchase is a lease combined with an option to buy the property within a specified period, usually three years or less, at an agreed-upon price.

In recent years, I have written several articles on LTOs, and they are among the most read on my website. The reason: LTOs offer the hope of home ownership to many who can't meet purchase requirements any other way. They also offer would-be sellers an opportunity to sell at a more attractive price than might otherwise be available.

Each side in an LTO transaction comes into it because of a weakness. In the buyers' case, it almost always is that they cannot qualify for the mortgage they need to finance a purchase. They may have a foreclosure on their record they must wait out or a credit score too low to meet lender requirements.

The LTO presents the opportunity to bet on themselves - the bet is that before the option period expires, they will qualify for the mortgage they need to exercise the purchase option.

In the sellers' case, the weakness is an inability to sell at what they consider the correct value. That could be because property values in the area have declined. The LTO offers the prospect of being able to sell in the future at a substantially higher price than is available today.

Another possible weakness that has become important in recent years is that the condition of the house is poor and the owner does not have the means to fix it. An LTO buyer is not as likely to be fussy about the condition of the house, and may be positioned to fix the deficiencies during the option period.

Contractual provisions. In a typical LTO arrangement, the borrower pays an option fee, 1 percent to 5 percent of the price, which is credited to the purchase price.

The borrower pays a market-rate rent and an additional payment that is credited toward the purchase price. The option fee, option period, rent, rent-credit payment, and purchase price are all negotiable. If the purchase option is not exercised, the buyers lose both the option fee and the rent-credit payment.

To the buyers, the option fee and rent-credit payment are part of the equity in the house they fully expect to own. To the sellers, however, these payments are the best guarantee that the house will sell; if it doesn't sell, the payments are retained as income.

That the benefit to the seller generally exceeds the cost to the buyer makes the lease-to-own deal a potential win-win.

Rent-credit payment. This is unique to LTO deals. It is an amount above the market-rate rent paid by the buyers that is credited back to the buyer at closing. Rent credits can be used in two different ways, which are not always distinguished.

The simplest approach reduces the sale price at closing by the total rent credit paid by the buyers. That reduces the required down payment only slightly. For example, if the sale price is $100,000 and the rent credit totals $5,000, the sale price becomes $95,000 and the down payment required at 5 percent falls from $5,000 to $4,750.

The rent credit is much more useful to the buyers if it can be used for the down payment in its entirety. If the rent credit of $5,000 in the example above is used in that way, the price of the house would remain at $100,000 but the buyers would receive $5,000 from the sellers at closing that could be used as down payment.

For that to work, however, the lender must accept the rent credit as legitimate savings by the buyers. To be sure that the rent credit is an amount paid above a fair market rent, the lender will require that the market rent be documented by an appraisal. To be sure that the buyers actually made the payments, the lender will want to see the canceled checks for the payments.

A more complete list of provisions that buyers and sellers can use in negotiating an LTO is on my website, http://www.mtgprofessor.com.

The LTO calculator. Mainly of interest to potential sellers, my LTO calculator, developed with Chuck Freedenberg of DecisionAide Analytics, allows sellers to view an LTO as an investment generating an attractive rate of return, relative to what the sellers could obtain by getting the best price in the current market.

The investment return is net of the costs of ownership during the option period, including mortgage-interest payments, property taxes, homeowners' insurance and other expenses of ownership. The calculator is available on my website.

Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.