In these situations there is normally an individual with a paid-off house, and another who wants to buy that house, but for some reason is having difficulty obtaining a mortgage to make the purchase. Other times there may be a parent or grandparent “selling” a house to their child or grandchild, without the use of a traditional mortgage.
In these circumstances, people often come to us asking if we can assist with a “lease-purchase.” Every time this happens I want to strangle someone. These types of transactions need to be kept as simple as possible, and a lease-purchase is a guaranteed way to over-complicate your way into making a bad decision. So, think of these types of non-traditional financing in 3 categories; 1. Seller Financing, 2. Lease with Option to Purchase, and 3. Lease-purchase.
SELLER FINANCING: When a seller finances the purchase of their property by the buyer, they are acting as the bank. They transfer title to the property to the buyer, and the buyer signs a note and security deed (mortgage) back to the seller. If the buyer doesn’t pay on time, the seller has to foreclose on the property in order to get it back. All terms of the mortgage (down payment, interest rate, number of payments, total purchase price) are completely negotiable. This means that both parties need to be able to do some basic financial calculations (such as loan amortization). If not, it’s pretty easy to learn, and there are lots of free mortgage calculator resources online. The payments made by the buyer are applied to principal and interest, and the buyer builds equity in the property as the payments are made.
LEASE WITH OPTION TO PURCHASE: If the seller does not want to have to go through the hassle of foreclosing on the property if there is a non-payment issue, then they need to keep the buyer as a tenant, rather than an owner. Often, though, a tenant is worried that the owner will sell the property before the tenant is in a position to get their own mortgage. In this scenario, the tenant may simply purchase an “option” on the property from the owner. The Option is an agreement that the owner will sell the property to the tenant on a certain date at a certain price, if the tenant is able to make the purchase at that time. If that time comes and the tenant (or option holder) is not able to “exercise” that option, then the owner is free to sell the property to someone else as he sees fit. Normally the option fee is not refundable. Payments made under the lease during the option period are just rent, and the tenant is not building equity in the house by virtue of the rent payments.
LEASE-PURCHASE: A Lease-Purchase is a bastardization of the two methods above. The tenant is still technically just a tenant, but a portion of his rent payments may be paying down the “principal” and building equity in the home. Why is this important? If the buyer misses payments, and the seller attempts to evict them, then the buyer may also be able to counter-claim that they have equity and are part owner of the property. This can muddy the waters as to whether the tenant can be evicted from a property they partially own, and also how much, if any, of their equity the seller has to return to them. Even if this can all get sorted out, the Magistrate Court (which normally handles evictions) will likely kick the case up to Superior Court, as only the Superior Court has jurisdiction on cases involving equity or ownership of Real Estate. Superior Courts are slower and more expensive. Lease-Purchases do not protect sellers, as getting their property back in the event of a default becomes very tricky. Lease-Purchases do not protect buyers, as they do not receive title to the property until the entire purchase price has been paid.
Of course their are other considerations that may come into play. The owner may still have a mortgage on the property, for example. There are other sub-categories, such as a contract for deed, which sort of fall into these categories as well.
The point of this post, though, is to point out the flaws with a Lease-Purchase. If you find yourself in a situation where you may be a buyer or seller in a seller-financing situation, please make your transaction as clean and clear as possible. Please define the roles either as landlord/tenant, with a purchase later, or as buyer/seller, with possible foreclosure later. Do not confuse the two.