What is a Lease Option?

Whether you are a buyer or a seller of a property, a lease option helps you to increase your chances of securing a deal. Read on to learn more about the benefits and trade-offs arising from the use of lease options and assess whether they are suitable for you.

What is a lease option?

A lease option, otherwise known as a lease with an option to purchase (OTP), is an agreement between the tenant and landlord where the tenant is given an option to buy the rental property from the landlord during or at the end of the rental period.

When the rental period is over, the tenant either fulfills the lease option or forfeits it. Such an arrangement usually prevents the landlord from attempting to sell the property to other potential buyers.

How does a lease option work?

Unlike a lease-purchase agreement which requires the tenant to buy the property when his lease expires, a lease option gives the tenant the choice to either buy the property or decide not to take any action. This allows the tenant with more flexibility compared to a traditional lease-purchase agreement.

In a lease option, the price of the property is established between the tenant and the landlord. Usually, the price is determined based on the current market value of the property, allowing the tenant to purchase the property in the future at today’s price, potentially reaping savings for the tenant, especially if the value of the property is projected to increase.

The lease option is beneficial for those who wish to purchase the property but may not have enough capital for the downpayment, or those who are building their credit score to qualify for a home loan.

Benefits of Lease Options

From a tenant’s perspective

As a potential buyer, lease options provide you with an avenue to purchase your preferred property in the event you require more time to accumulate savings or build up your credit score. Renting the property first allows you to save money and in the meantime, enables you to improve your credit score by making consistent rent payments.

If you foresee the price of the property to increase over time, a lease option would allow you to accumulate savings to finance the future purchase of this property.

From a landlord’s perspective

As a landlord and seller, a lease option enhances your opportunity of selling your property in the event you face challenges trying to sell it. You not only secure a potential buyer without even listing your property on the market, you earn an additional income upfront from the tenant for the lease option. In the event the tenant does not exercise the OTP, you have the right to retain the additional funds that the tenant has paid.

Trade-offs on lease options

From a landlord’s perspective

Potential loss of earnings
By agreeing to a lease option, you miss out on the opportunity to sell the property to other potential buyers for a higher price in the future, as the lease option only allows you to sell it to the tenant unless he chooses not to exercise his right to buy the property. Furthermore, the lease option allows the tenant to purchase the property in the future at today’s price. To mitigate this, you can charge an additional sum on top of the monthly rent for the option to purchase the property at today’s price when the lease expires. This enables you to gain additional cash upfront before selling the property.

From a tenant’s perspective

Rental payments
You have to pay more upfront every month for the option to purchase the property in the future at the current market price. This premium is usually calculated based on a percentage of the current rent. For example, the landlord can place a 10% premium on top of the standard rent. However, the premium, otherwise known as rent credit, goes towards the downpayment for the property in the event you choose to buy the property. However, if you decide not to proceed with the purchase, you forfeit the extra money paid on top of the standard rent.

Read also: What is Tenancy in Common?

Bank loans

Usually, banks allow the rent credit that tenants pay to be considered as a part of the downpayment for purchasing the property. However, if the rent was charged at the market rate without any premium, banks may not allow for any portion of the rental payment to be applied towards the down-payment of the home. Therefore, it is important to check with the banks to better understand individual financial institution’s policies regarding mortgages of properties with a lease option.

The bottom line

A lease option is a beneficial way for sellers to secure potential buyers without going through the hassle of listing the property in the market and potentially engaging in lengthy negotiations. As a buyer, you are also able to purchase the property at a lower price after renting the property for a period of time and provide you with the ability to build your savings and credit score while you prepare to buy the property. Therefore, for a pair of willing buyer and seller, this option can create a ‘win-win’ situation for both parties.

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Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.