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Mortgage

What Is a Lease-to-Own Home and Is It a Good Option?

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

You’ve heard of a car lease, but what about a lease-to-own home? In this scenario, a tenant agrees to a lease with an option to purchase the property down the road, typically no more than three years from signing the agreement. Set forth within that document are the rental payment amount, accrual toward down payment and the home’s sale price. But does this make sense for your personal financial situation?Many who enter into these agreements do so because issues such as lack of a down payment or credit problems may block them from a traditional purchase. In a nutshell, they are able to use the rent they will pay before purchasing as their down payment.

However, there are a few risks to consider up front: Primarily, the lease-to-own industry has been pockmarked with less-than-ethical dealings, and consumer protections have been slow to emerge in response. That said, it can simplify the ownership process for people who wish to buy but find themselves in a tough financial spot.

Renting to own is not a terribly common choice. In fact, according to the 2016 Profile of Home Buyers and Sellers produced by the National Association of Realtors, just 1% of those purchasing a home in 2015 were renting to own.

Lease-to-own homes: What’s the process?

You’ll choose between two types of rent-to-own arrangements:

  • A lease-option agreement, which requires a nonrefundable deposit at the beginning of the lease term as part of the purchase price — money that will be kept, should the tenant decide not to buy the property
  • A lease-purchase agreement, which does not require that any money be paid upfront, but is more concrete in what it sets forth, including when the purchase price will be decided and a date when the sale will take place

Throughout the life of the lease, you’ll be paying rent as you would with any standard tenant agreement. However, the meat of that agreement is different than with your typical landlord-tenant contract, as it spells out terms under which you as the tenant will eventually purchase the property.

Sounds great in theory, but how does it work in reality? If you have a lease-option contract, you’re on the hook to find financing to pay off the balance of the purchase price — and if you can’t, you’re out any money paid up until that point. This gets dire if your contract is lease-purchase, as you could be sued if you can’t or won’t buy the property as agreed.

“You might be told it’s a chance to ‘stop throwing money away on rent,’” Federal Trade Commission consumer education specialist Amy Hebert wrote in an online brief. “But we’ve heard that many people who thought these deals were a path to owning a home watched their dreams disappear instead.”

Understanding lease-to-own contracts

When you sign a lease-to-own contract, it will include:

  • The lease or rental agreement, which stipulates that the landlord will retain the title to the home until the tenant exercises the option to the property. Like a typical rental agreement, it also includes terms like the amount of monthly rent, the lease period and the division of maintenance and repair responsibilities between landlord and tenant.
  • The option provisions, which include purchase price, the amount of time the tenant has to complete the transaction, the option fee, which is typically 1% of the purchase price and rent credit, a 10% to 15% premium above market rent that is collected by the seller and rolled into the down payment when the purchase goes through.
  • The purchase provision, which must denote the option fee, the purchase price and the duration of the option period.

What to do before signing a lease-to-own contract

Before signing on the dotted line, you need to take the following steps:

  • Have an attorney review the agreement — local knowledge is key, as different states have differing laws about rent-to-own contracts — and have him or her rework it to be as favorable to you as possible.
  • After your attorney gives his or her approval, get in touch with a lender. Make sure the lender also reviews the contract, and ask to be prequalified; both steps will give you more reassurance that you will be able to handle the purchase down the road.
  • Get a qualified appraisal and inspection before signing anything so that you know exactly what you’re dealing with upfront.
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Pros and cons of lease-to-own home programs

Benefits of these programs include:

  • Buying without having to qualify for a traditional mortgage
  • Building equity in your home before the actual purchase
  • Locking in current prices in an escalating market
  • Testing the neighborhood out before committing to it
  • Saving the hassle of a move later on
  • Being made to save a down payment through rent credits

However, there are drawbacks.

If you fail to qualify for a loan at the end of the lease, be prepared to lose money that you’ve invested through an option fee, rent credits and rent itself, making the property a rental for which you’ve paid above market rate for no return.

Some contracts specify that you are legally obligated to purchase the home at the end of the lease, so if you’re not careful, you can get yourself into legal issues with a contract that you aren’t able to honor.

The dark side of lease-to-own programs

The lease-to-own industry has had its share of controversy. In her online brief, Hebert writes: “In a rent-to-own deal, the person or company that owns a home agrees to sell it to you in the future for a specific price. Rent you pay now is counted toward your future down payment on the house. But these deals can be risky — and even flat-out scams.”

Such scams, as outlined by Hebert, include finding out the following.

  • The property owner has failed to pay taxes on the home
  • The seller does not truly own the property
  • The house is a foreclosure
  • The home is in poor shape or has major issues like asbestos or lead
  • Promised repairs are not made after the signing of a contract

Moreover, a National Consumer Law Center report finds that land contracts, which proved popular with investors because borrowers who defaulted were without traditional mortgage protection and could be rapidly evicted — preyed largely on African-American, Latino and immigrant populations. These contracts, which placed the responsibility of upkeep on the renter (and would-be owner), were also deemed as “a transaction built to fail.”

The lesson: Buyer beware. Watch out for scams.

Conclusion

While rent-to-own contracts may seem appealing as an alternative to traditional home purchases, those looking to sign such an agreement should proceed with caution. This may be a worthwhile option for consumers who have a clear path to homeownership but a few temporary barriers to getting started. But it also can be risky, controversial and downright dangerous for the wrong people in the wrong situation.

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Mortgage

Getting Preapproved for a Mortgage: A Crucial First Step

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

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Getting a mortgage preapproval is a crucial stepping stone on your way to becoming a homeowner, but it doesn’t mean you’re in the clear to borrow from a lender just yet. A preapproval does give you a leg up over the competition, though.

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What is a mortgage preapproval?

A mortgage preapproval means a lender has vetted your credit and finances and has made an initial loan offer based on its findings. Lenders share this information in writing, so you may hear it referred to as a preapproval letter.

Getting prequalified for a home loan is not the same as a preapproval. Mortgage prequalification provides a rough estimate of how much you might qualify for, based on a surface-level review of your financial information.

A preapproval, however, is a more thorough vetting of your finances and provides a more accurate idea of what a lender may offer in terms of a loan amount and interest rate. You provide financial documentation and agree to a review of your credit profile, which means the lender will pull your credit reports and scores. With a prequalification, you typically self-report your financial information and lenders don’t check your credit.

5 steps to getting preapproved for a mortgage

It’s not worth falling in love with a house until you know the sales price matches up with a mortgage amount you can realistically afford. Here’s how to get preapproved for a mortgage.

  1. Determine your homebuying timeline. The best time to apply for a mortgage preapproval is before you start house hunting. You may want to hold off on a preapproval if you’re not quite ready to begin the homebuying process. Even if you’re not yet prepared, you can get started by pulling your free credit reports from each bureau at AnnualCreditReport.com and reviewing minimum mortgage requirements.
  2. Review and improve your credit profile. With your credit reports in hand, it’s time to look for areas of improvement. The minimum credit score you need for a mortgage varies by program type, but you’ll need at least a 620 credit score in many cases. Dispute any inaccurate information you find, keep your credit card balances low and consistently pay your bills on time. Refrain from applying for new credit and closing any of your existing accounts, too.
  3. Pay down your debt. Pay down your debt. Aside from your credit scores, lenders care about how you manage your debt now and how you’ll fare if you get a mortgage. Your debt-to-income ratio, or the percentage of your gross monthly income used to repay debt, should stay at or below 43%. The less debt you have, the less risky you appear to lenders.
  4. Gather your documents. Lenders will request several documents from you for a preapproval, including:
    • Government-issued photo ID
    • Social Security number
    • Bank statements from the last 60 days
    • Pay stubs from the last 30 days
    • Two years of W-2s or 1099 tax forms
    • Credit reports and scores from all three bureaus
  5. Apply with multiple lenders. Consider banks, credit unions, mortgage brokers and nonbank lenders when applying for a mortgage preapproval, and shop around with three to five lenders to get the best rates. Additionally, keep your shopping period within 14 to 45 days to minimize the impact of those credit inquiries against your credit scores.

How long does a mortgage preapproval last?

A mortgage preapproval typically lasts for 30 to 60 days. The average time to close on a house is 48 days, according to Ellie Mae’s latest Origination Insight Report, so there’s a chance you can get through the full homebuying process before time runs out.

If your preapproval letter expires before you close, you’ll need to go through the process again, submit documentation and have your credit reports and scores pulled, which creates a new credit inquiry and affects your score.

Pros and cons of mortgage preapproval

The mortgage preapproval process includes several benefits, but there are also drawbacks to consider.

Pros:

  • You’ll get a better idea of how much house you could afford, which helps narrow down your price range.
  • Home sellers take you more seriously because you’ll have proof that a lender is willing to back you when you submit an offer.
  • You can comparison shop before committing to a lender.
  • Even if your preapproval is denied, you may walk away with an analysis of where you stand financially and how you can improve.

Cons:

  • A preapproval is not a full approval. It doesn’t guarantee you’ll qualify for a mortgage.
  • Preapprovals typically last for 30 to 60 days. If you don’t buy a home within this time frame, you’ll need a new mortgage preapproval letter.
  • Making changes that affect your credit, such as applying for a new credit line or racking up debt, can prevent you from getting a full mortgage approval.

What happens after you get preapproved for a mortgage?

Once you’ve been preapproved and have chosen a mortgage lender, it’s time to find your home and submit an offer to buy it. You’ll also continue working your way through the mortgage approval process, which includes:

  • Providing your lender with any additional documents needed to finalize your loan.
  • Getting a home appraisal and home inspection.
  • Preparing for your walk-through and closing day.

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Bridge Loans: What They Are and How They Work

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If you’re shopping for a home in a hot real estate market, you might find that sellers aren’t willing to wait for you to sell your home before you buy. In that case, a bridge loan can help you purchase your next home without the pressure of selling yours first.

Before you take the plunge into the bridge lending world, learn the ins and outs with this guide to understanding bridge loans.

What is a bridge loan?

A bridge loan is a short-term mortgage you can use to access equity in a home you are selling in order to purchase a new home. Bridge loans are commonly used in tight housing markets where bidding wars demand competitive purchase offers without any contingencies.

How does a bridge loan work?

Bridge loans work in two different ways — as a first mortgage to pay off your current loan and fund the down payment of a new house, or as a second mortgage, with the money applied to the down payment of a new home. Let’s explore how each of these work.

First mortgage bridge loan: One large loan is taken out for up to 80% of your home’s value. The funds are initially used to pay off the current mortgage balance. Any extra money leftover is used toward the down payment for your new home.

Second mortgage bridge loan: This option involves borrowing the difference between your current loan balance and up to 80% of your home’s value. The mortgage on your current loan is left alone, and the second mortgage bridge funds are applied to the down payment on the home you’re buying.

Here’s an example of how each option would look if your current home is worth $350,000 with an outstanding loan balance of $200,000, assuming you borrow 80% of your current home’s value.

Bridge loan optionMaximum loan amountHow funds are applied
First mortgage bridge loan$280,000$200,000 to current loan payoff

$80,000 to down payment new home
Second mortgage bridge loan$80,000$80,000 to down payment new home

Pros and cons of buying a home with a bridge loan

Pros

Tap home equity while your home is for sale. A bridge loan lets you tap the equity you’ve built in your current home while it’s for sale to buy a new home. Standard lending guidelines for conventional loans don’t allow cash-out refinancing on a property listed for sale.

Avoid making an extra move. A bridge loan allows you to move while your current home is still being sold so you’re not stuck finding a temporary place to live if you can’t time both sales perfectly.

Pay off the balance of your current loan and get extra cash. If you have a significant amount of equity in your home, you may be able to pay off your current mortgage while you wait for your home to sell. You can then use any extra cash toward a bigger down payment on your new home. This prevents you from paying two mortgage payments until your old home is sold.

Use bridge funds as a second mortgage to buy your new home. If your current mortgage rate is low, paying the entire balance off with a bridge loan doesn’t make sense. If you borrow the equity you have you in your current home as a second mortgage, you’ll have a lower bridge loan balance and payment.

Buy a new home without waiting for your current home to sell. A bridge loan eliminates the need for a home sale contingency, making your offer more competitive in a tight housing market.

Make interest-only payments until your home sells. Some bridge loan programs offer an interest-only option, which means you pay only the interest charges accruing each month. The interest rate may be slightly higher, but it will soften the impact of having two monthly mortgage payments.

Cons

You’ll make two or three mortgage payments. Once you borrow against your equity and buy your new home, you’ll be carrying at least two, possibly three monthly mortgage payments, depending on how you use the bridge loan. This can add up fast and become unsustainable.

Higher interest rates and closing costs. Like most short-term lending options, bridge loans come with higher interest rates and closing costs. Lenders charge higher rates and fees to make it worth their while because you are borrowing only for a short time. You might have trouble making the payments on both mortgages if you have a hard time selling your current home.

Increases the risk of defaulting on two mortgages. Bridge lenders expect you will be able to pay off the loan within a year. If the balance isn’t paid by then, they can foreclose on your home. As a result, your credit and finances will take a massive hit, and you might be unable to repay the mortgages on both homes.

Need substantial equity to qualify. Bridge loans are not a viable choice if you don’t have a good chunk of equity in your home. You can borrow up to 80% of the value of your home, so if you’re in an area where neighborhood values have dropped, you’ll want to come up with alternative financing.

Not as regulated as traditional mortgages. When regulatory reform was passed, it was intended to focus on long-term loan commitments to protect borrowers from taking out loans they couldn’t repay. The new rules don’t apply to temporary or bridge loans with terms of 12 months or less, meaning you’ll have less protection.

How to qualify for a bridge loan

Bridge loans are specialty mortgage loans, and they aren’t approved based on the same standards as a regular mortgage. Lenders that offer these loans have a few extra qualifying hoops for you to jump through, and rates and fees vary depending on property type, too.

Here are some key qualifying requirements unique to bridge loans:

Enough income to cover multiple mortgage payments

Bridge lending guidelines are often set by private investors or are specialized programs offered by institutional banks. That means they can create their own guidelines. Some bridge lenders may not count your current mortgage payment against you because they approve the loan knowing your intent is to pay it off quickly.

Other lenders will require you to qualify with both loans, which could mean you can’t tap into the full amount of your equity unless you have enough income.

At least 20% equity in your current home

Bridge loans work best if you have more than 20% equity, but the bare minimum requirement is 20%. If you don’t, it’s unlikely you’ll qualify for a bridge loan.

A commitment to paying off the loan quickly

Bridge lenders will scrutinize the home you are selling more than the home you are buying to make sure it’s priced to sell within bridge loan’s term period, usually 6 to 12 months. An appraisal will be required on your current home, and if the value comes in significantly lower than what your asking price is, your loan amount will be reduced.

Average closing costs for a bridge loan

Bridge loan closing costs typically range from 1.5% to 3% of the loan amount, and rates can be as high as 8% and 10% depending on your credit profile and how much you are borrowing. Beware of any lender that asks for an upfront deposit to approve a bridge loan; they probably aren’t a legitimate lending source and you should steer clear.

How to find a bridge loan lender

Bridge lending is a niche product, so not every lender will offer the option. You’ll need to shop around with mortgage brokers and institutional banks. Also, ask your current mortgage broker or loan officer whether they have experience closing bridge loans.

Work with a legitimate, licensed loan officer. You can check licensing requirements for all 50 states with the Nationwide Multistate Licensing System Consumer Access link. Type in your loan officer’s name or company information. Here are examples of lenders who may offer bridge loans:

Institutional lenders

Start with your local bank to discuss their bridge loan programs. If you have a substantial amount of deposits with a bank, the bridge loan terms might be more flexible and approval might go more smoothly.

Alternative lenders

Mortgage brokers and mortgage bankers often have relationships with alternative lenders. They can often find a bridge loan source if your current bank doesn’t offer them.

Hard money lenders

A hard money loan may be a good fit for bridge financing to purchase fix-and-flip investment property. Hard money lenders are often private investors, or groups of private investors, looking for high returns on short-term real estate loans. Interest rates can run into the double digits, and you can expect a prepayment penalty and fees range between 2% to 10%, depending on how risky your credit profile is.

Alternatives to using a bridge loan

You can do some advance planning to avoid needing a bridge loan, or at least limit how much bridge financing you need to purchase a home. Here are some other options to consider:

Use an existing home equity line of credit (HELOC)

If you already have a HELOC on your home before you start searching for a new home, you can use the HELOC toward a down payment on your new home. Typically there are no limitations on how you can use HELOC funds. A few drawbacks: You might have to pay a close-out fee when your home sells and the HELOC is paid off and closed, and you won’t get a mortgage interest tax deduction on the extra borrowed equity. You also risk losing your home if you can’t repay the loan because your home is serving as collateral for the loan.

Take out a 401(k) loan

Your retirement savings account can be another tool to bridge the gap in financing, and the rates and payment may be significantly less than what you’ll pay for a bridge loan. Check with your plan provider for any restrictions on loans for home purchases. It may be more cost-effective to take out a 401(k) loan to avoid the closing costs and high interest rates that come with a bridge loan.

The drawback to a 401(k) loan is that the borrowed money is taken from your retirement savings and won’t be working for you in the market. Consider this option only if you plan to repay the loan immediately after your current home sells.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

By clicking “See Rates”, you will be directed to LendingTree. Based on your creditworthiness, you may be matched with up to five different lenders in our partner network.