Becoming a Homeowner When You Don't Currently Qualify For a Mortgage

Lease-to-own contracts (LTOs) and land contracts (LCs) are different legal ways to transfer occupancy of a property from an existing owner who does not want to occupy it to someone else who does, but who cannot qualify now for the financing required to purchase it outright. Both LTOs and LCs offer wannabee owners the right to occupy a house for a period during which they can improve their capacity to qualify for the financing they need to complete the deal.

Note: The LC designation includes what are called "contracts for deed" which are used in the same way. Detailed provisions of both vary from state to state.

The LTO Transaction

With an LTO, the new occupant becomes a tenant and the current owner becomes a landlord who offers the tenant an option to purchase the house within a specified period. The tenant will need a purchase mortgage when the time comes.

As an example, assume a house appraised for $100,000 that cannot be sold outright at that price but the price is acceptable as the option price under an LTO. The renter/buyer has the right to occupy the house with an option to buy anytime within 18 months for $100,000 in exchange for a non-refundable option fee of $1500 and monthly rent of $900 for 18 months. If the wannabe buyer cannot qualify for the mortgage required to exercise the option within the 18 months, her option lapses and she must vacate at the end of the period.

The LTO offers the wannabee homeowner an opportunity to bet on herself. To become a homeowner, she must either improve her credit score, or accumulate the funds required for a down payment on a purchase mortgage, or both.

The LTO offers the seller a chance to obtain a better price than is otherwise available. If it turns out that the buyer cannot complete the transaction, the seller retains the option fee and rent, and recovers the house, perhaps to offer it again to another wannabee owner. If the seller had a mortgage, it would not be affected by an LTO that fizzled.

Price changes that occur during the option period do not benefit the wannabee owner. If the house declines in market value, purchase at the option price becomes less attractive. If the house appreciates in value, purchase at the option price becomes more attractive, but the capacity to make the purchase will not increase. The maximum available mortgage amount will be based on the option price, not the current market value, so that the required down payment will not change.

The LC Transaction

With an LC, the new occupant purchases the property with financing provided by the seller, who becomes a lender. But legal title does not pass until the loan is paid off, which requires the new occupant to refinance.

As an example, under the LC, the wannabe buyer pays $100,000 for the house, including $1500 in cash as a down payment, with the seller providing a loan for $98,500. The monthly payment of $900 covers the principal and interest plus taxes and insurance, with the loan balance of $96,658 after 18 months due at that time. If the wannabe buyer cannot refinance, the owner does not transfer legal title and can take steps to have him evicted.

To wannabee owners, an important difference between LTO and LC deals is that completing the first requires a purchase mortgage while completing the second requires only a refinance of the mortgage granted by the seller. Closing costs are lower on a refinance, and the down payment required is smaller. The $1500 that went into the seller's pocket as an option fee on the LTO became buyer equity on the LC.

Furthermore, since the equity required on the refinance is based on a current property appraisal, an increase in market value during the 18 months will reduce and could even eliminate the need for the buyer to come up with additional cash. In the example, a lender imposing a 10% equity requirement on refinances would refinance the entire $96,658 balance after 18 months if the market value of the house had risen to $107,500.

The Current Wave of LCs

As a delayed consequence of the financial crisis and the marked rise in foreclosures that followed, large numbers of homes that had been in foreclosure are now being marketed with LCs. Rising home prices in many areas are encouraging this process, and many wannabee homeowners of modest means are being offered homes at prices that look like great bargains. I asked my colleague Jack Pritchard, an ex-mortgage banker who knows every trick of the trade, how potential buyers of foreclosed homes should protect themselves against disappointment. This is his advice:

  1. Have a title company or closing attorney verify that a) there are no senior liens on the property, and b) your contract of sale has been recorded. This will cost about $150, but it eliminates the risk of your having to pay off the seller's debt, and it positions you for the refinance you will need to pay off the seller.

  • Find a way to make the monthly payment before the due date every month. This eliminates the risk that the seller will call a default if your payment is one day late in order to take the property back and sell it to someone else.
  • Make your payments to the seller in a way that can be easily documented - for example, by check. This will ease your way to the refinance you will need to distance yourself from the seller.
  • For more information on creative ways to finance a home purchase, or to shop multiple mortgage lenders in an unbiased environment, visit my website The Mortgage Professor