Lease Option or Seller Finance?

leaseoption290When a real estate market turns soft the property marketing ads become peppered with offers to lease option and owner finance.

Most property owners understand the seller’s market has quickly turned to a buyer’s market requiring them to think creatively and consider concessions.

As sellers try to shorten listing times, entice buyers, and compensate for the tightening credit markets, they start turning to creative financing solutions like lease options and seller financing.

A Lease Option allows a potential buyer to lease or rent the property with an option to later purchase the property.  The option money paid by the buyer is generally nonrefundable however, a portion of the lease payments are often applied towards the purchase price. 

Seller Financing involves a property sale where the owner agrees to finance all or a portion of the purchase for the buyer.  Also known as owner financing, the buyer makes payments over time to the seller rather than obtaining a traditional mortgage or bank loan.

With many owners, investors, and real estate agents taking these old standbys down from the back shelf it is a good time to blow off the dust and take a look at the pros and cons of each option.

Seller Financing

  • Pro: A down payment is generally greater than the upfront option consideration.
  • Pro: The real estate taxes, property insurance, and upkeep are the responsibility and cost of the buyer.
  • Pro:  The buyer is more likely to show the care and mindset of an owner since they have already purchased the property. While a lease option tenant is usually better than the average renter, they still are not an actual owner until they exercise the option.
  • Con:  If the buyer becomes delinquent on payments it can take more time to foreclose than an eviction process.
  • Pro:  The seller can earn interest on the amount financed.  In general, a 30-year mortgage can result in a buyer paying back about 2.5 to 3 times the amount financed depending on the interest. For example, a $100,000 mortgage note financed at 8.5% with 360 payments of $768.91 will result in the buyer paying back $276,807.60 over 30 years.
  • Pro: There is greater liquidity with note payments than lease payments.  It is easier to find investors that will pay cash now for real estate note payments.
  • Con: The term or time of repayment repay can be longer on a seller financed note.  If 10 to 30 years feels like a long time to collect payments simply include a 3-5 year balloon payment as part of the original note terms.  This can also help pricing should the seller ever decide to sell the note payments to an investor.

Lease Option

  • Con:  The seller will have more expenses since they generally pay for the real estate taxes and property insurance (although some lease purchase agreements might commit the buyer for these expenses).
  • Pro:  If the buyer misses payments the eviction process can be faster than a foreclosure process, especially when bankruptcy filings are involved.
  • Con: There is no guarantee the tenant will exercise their option to buy.  This could leave the seller starting the process of finding a buyer all over again.
  • Pro:  In an appreciating market the seller might gain some upside from increased value if the agreement allows or the tenant fails to exercise the option to purchase.

So is it better to owner finance or lease option?  As you might have guessed, the final answer is “It depends”. 

While the list of pros might give weight to owner financing there are times a lease option will make more sense.  If the offer involves a potential buyer with a small down payment and weak credit, the lease option would have a strong advantage.  Not only does it give the buyer time to improve their credit and financing options, it will be easier to remove them from the property if they default. The less equity and the lower the credit quality, the more likely a payer will default.

The final decision between a lease option versus seller financing will depend on the financial needs and tax considerations of the seller balanced by the buyer’s stability, credit history, and down payment funds.

It pays to seek the advice of competent professionals when considering creative financing like seller financing or lease options to sell property in a soft real estate market.

 

 

About Tracy Z

Tracy combines her knowledge of cash flow notes with the power of marketing online to help grow your business! She can be reached at Tracy@NoteInvestor.com 1-888-999-7905 or at Exposure One Marketing.

Comments

  1. Steve Sullivan says:

    Tracy,

    I there a “rule of thumb” guide on what note buyers will pay for a typical seller financed note?

    I have a house that my tennant wants buy and I would like to know what my cashout options are. I am thinking my terms will 7.5% on a 30yr note with a 5 year balloon. My tennant has never been late in three yaers, but is self employed.

    $140k w/ 10% down
    rent = $1,700/month
    His payment would go down about about $300/month includung taxes and insurance.

    Thank you
    Steve

  2. Is there a concern that seller financing would trigger an alienation clause in the underlying financing?

  3. My husband and I are considering a Lease to Purchase on a home. They do not owe on the property and now I am wondering if they might be willing to do a Seller financing. We wouldn’t have down payment to offer but they may be willing to go without. I am wondering if we were to do seller financing would we then be able to do a third party loan to take over the financing lets say 10 years? The issue for us to get a loan at the the price of the home today is we can’t qualify for that much yet. After 3-4 years we would have enough to down payment in the lease option to bring down our loan to an affordable amt. The house however would need some upgrading to go FHA, it is old but well maintained. There are issues such as electrical (besides the kitchen) that need to be brought to code. This is a concern to me bc we will probably need to do a Rehab loan in order to use FHA. So, could doing a Seller finance situation work best for us? Say at 10 years we could then get a third party FHA loan to pay off the remainder of the loan. We would then have paid down the loan a significant amt. so that we could get qualified and get the rehab loan ontop. If you think this would be a good option, how would I approach the seller for this? What are the top reasons this would be good for him. How would a balloon work?

    By the way, here is our scenario, asking price of 245K Monthly payment of $1000 but $920 actually goes towards the loan.

    Thank you!

    • Hello Angela,

      Seller financing can be a great alternative option for buying a home when bank financing is hard to obtain. Many elect to owner finance and then refinance with a mortgage loan once they have increased their equity through amortization or improved their credit score.

      Of course the first step is to approach the seller and agree to terms that are favorable to both of you. Some sellers may want you to show timely payments on a lease option before agreeing to owner finance (especially when there is not a down payment).

      You will also want to order title insurance and talk with an attorney and/or closing agent to be sure documents are recorded to protect your interest.

      Also speak to a lender to know what things you will realistically need to address so that you are prepared to meet all requirements when the time comes to payoff the seller financing. In all honesty it is unlikely they are going to give you rehab money on top of the purchase money on a zero down deal. That means coming out of pocket and using sweat labor to finish the repairs.

      If considering a balloon payment promissory note be sure you are prepared to payoff the balance in the stated amount of time. Another option is to include a clause that gives you the right to extend the balloon if unable to obtain financing from a bank. Since I’m not an attorney, and I don’t play one on TV :), please seek competent legal advice when entering into any contractual arrangement.

      We have other tips for both buyers and sellers in the Owner Financed Resources area of this site. Thanks for reading and commenting at Note Investor!

  4. bobby smith says:

    i am in lease purchase been hear for four yrs what is a better way of financeing other than the ower and not lose all the money i have paid

    • When it comes to financing the purchase of property there are three main options:

      1) Bank loans
      2) Private money loans
      3) Seller Financing

      If one of these options does not work, you might consider asking the seller to extend the terms of the lease purchase. In the current real estate market it is unlikely values have increased and many sellers/property owners are happy to have someone in the property that has made timely payments for four years! Of course that is a great argument for getting the seller to carry the financing at a reasonable interest rate!

      It is also worth taking a hard look at whether staying in the same property is your best financial strategy. If prices have gone down substantially it could be that similar properties are now selling for far less than what you have invested in the current lease purchase situation. Be sure that if you exercise the option to purchase you are not starting out in a negative equity situation!

      Thanks for reading an commenting at Note Investor.

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