Reports of abuses are surfacing about this tempting approach to home purchasing. It can be worth doing, but be aware of the potential pitfalls.
Many people who want to buy homes can’t quite qualify for a mortgage. Maybe they don’t have enough money for the down payment — even a super-small FHA down payment. Or their credit scores, while not horrific, aren’t good enough to get a mortgage, at least one that’s affordable.
An alternative way to buy
When it’s hard to get credit, buyers sometimes use an alternative method of buying a home called a “contract for deed” — otherwise known as a “lease with option” or “rent to own.” The seller, not a bank or mortgage company, finances the home purchase. But these agreements are different from the usual seller-financed mortgage. Buyers have few protections, and sellers keep most of the control.
Contract-for-deed agreements vary a great deal, but, unlike in a more common property sale, the buyer doesn’t buy the home right away but instead pays a fee for the right to purchase it at some later point. Until the purchase is complete the buyer can live there and pay rent, some of which is applied to the purchase price of the home.
Rent-to-own contracts have attractions for both buyers and sellers.
- get a chance at home ownership, even with a lower credit score.
- get time to gather a down payment and improve their credit scores.
- get a locked-in purchase price, even if local home prices are rising.
- earn a nice income stream on a property.
- may earn a higher-than-market purchase price or interest rate (or both).
- avoid high real-estate agent sales fees and other expenses like closing and settlement costs.
- find a way to sell a property when the local real-estate market is slow.
It could be a scam
The devil, as they say, is in the details. If you are considering signing one of these contracts, be super careful. Although some consumer housing agencies use contracts for deed to help low-income clients get homes, they often are associated with cons and scams. To be sure, not all contracts for deed are scams. But scammers do often use them to fool people yearning to own a home.
Here are a few of the many things that make this type of deal hazardous for buyers, according to the Minneapolis Federal Reserve:
- These are complex contracts. Everything is up for negotiation. Buyers have few protections.
- The home you buy may have hidden problems, including building and safety code violations, and you could be held responsible for repairs you can’t afford, forcing you to lose the entire investment.
- The seller may be able to put a lien on a home under contract and leave the buyer responsible for it.
- Sometimes sellers are hit with foreclosure or bankruptcy, canceling the deal.
- Buyers violating any provision of the contract — making just one late payment, for example — may lose their home.
- Buyers often have to pay for property taxes, home insurance and home repairs or risk losing the property.
- Your payments probably won’t improve your credit score since few sellers report buyers’ payments to credit bureaus.
In a contract for deed, buyers pay a nonrefundable fee for the option to buy the home later at a certain price. Depending on the contract, this fee may be applied to your purchase when you buy. These option fees run about 5 percent of the purchase price, plus or minus a few percentage points, says About.com’s banking expert Justin Pritchard. Don’t pay more because you’ll probably lose the money if you don’t buy the home.
The contract sets a time frame for closing the purchase — one to five years is typical, experts say. At that date the buyer must produce the entire purchase amount — a “balloon” payment — to buy the home, usually by obtaining a mortgage.
But some contracts run as long as 40 years, the New York Times reports. Unlike with a standard mortgage, you’ll have no ownership stake (equity) in the home and won’t get the deed until you have paid it off completely. If you don’t buy the home you forfeit the money you’ve paid.
According to the Minneapolis Federal Reserve, poorer buyers and those whose cash incomes make it hard to qualify for a mortgage are typical big users of contracts for deed. Thousands of cheap, run-down homes, many of them foreclosures, were purchased by investors who now sell them to buyers through contracts for deed, especially in the Midwest and South, says the Times, adding:
“They (investors) do not take care of the code violations with these properties, which is why they are trying to pass them off to other people,” said Jill Steele, city attorney for Battle Creek, Mich.
Ms. Steele said Battle Creek has had a number of code violation issues with Harbour Portfolio Advisors, a firm out of Dallas that is one of the larger national players in the contract for deed business.
If you are considering using a contract for deed, it’s well worth the cost to get advice from an experienced real-estate attorney. Trulia, a real-estate marketplace, has tips for finding and hiring one. Check an attorney’s credentials with the bar association in your state (or find your state and search here).
What’s your experience or impression of buying or selling homes with a lease-to-buy option? Share with us in comments below or on our Facebook page.