With all the things that can go wrong with a lease option, the prospective buyer is often more vulnerable than the seller. How so? Because the buyer does not have any automatic recourse unless they take steps to protect their interests in the transaction.
What can go wrong with a lease option?
What can go wrong with a lease option? Many different things.
Even as you are making payments directly to the seller (a big mistake) the seller could default on their first mortgage or take out a second mortgage on the property behind your back and wipe out the equity. On top of this, third parties’ liens and judgments could attach to the property. Any of these scenarios would make an attempt to execute your option a financial suicide. In the meantime, the property you hoped to own at some point in the future could get foreclosed upon from under you (even though you have been paying on time all along). In a slightly more extreme scenario, the seller could file for bankruptcy.
Should any of this happen, your lease option would become worthless and you would lose whatever payments you hoped to put down towards the purchase price.
You have’t been paying a lease all this time for the property to be foreclosed upon right from under you.
This doesn’t have to happen. With a few simple steps you can protect your interest in a lease option agreement and here is how.
Make Sure the Mortgage and Property Taxes Get Paid On Time
Paying directly to the seller could land you in big trouble. Luckily, the old adage “Trust, but verify” can be put into practice in many different ways.
You could send your payments through an escrow service, but unless the payments are large enough this solution could be an overkill.
You could make the check you are sending to the seller payable to the lender in the amount of the mortgage, with a stamped and pre-addressed envelope for easy forwarding.
Some lenders handle property taxes (and calculate a prorated amount into the monthly payment), but make sure this is happening otherwise you could see tax liens attach to the property.
It could prove very wise to ask the seller to sign an Authorization to Release Information for you. This will allow you to talk directly to the lender and verify that the seller remains in good standing.
For an Authorization to Release Information to give you any real leverage with teeth, however, you also need the seller to sign an Authorization for Direct Payments. This will allow you to pay off any debts owed by the seller to a third party (such as the lender), thus preventing them from placing a lien on or foreclosing on the property, and count these monies towards your payments under the lease option agreement. At the end, it is all about having options, isn’t it.
File a Memorandum of Agreement with the County Clerk
You can file what is called a Memorandum of Agreement (MoA) with the county clerk to put it on record and cloud the title of the property. This step does not require the seller’s consent. It will not prevent liens and judgments from attaching to the property but will make it more difficult for the seller to find another buyer (and sell the property from under you) or obtain a second mortgage. By registering your interest in the property, dependent on the wording of the agreement, you may obtain some protection should the seller file for bankruptcy.
If you really want to prevent liens and judgments from attaching to the property you could, in theory, put the property into a Trust. This won’t give you protection in case of seller’s bankruptcy or (unless you are made the Trustee) from an attempt to sell the property right from under you. It also requires the seller’s cooperation which might not be so easy to obtain.
Put Documents into Escrow
Involve a third party in the transaction. In addition to filing a Memorandum of Agreement or Performance Mortgage with the county clerk, have the seller escrow a Warranty Deed from the seller to you and a Quit Claim Deed from you to the seller. You can use the services of an attorney or a title company. When you pay off the debt, you will receive the deed. Should you default, the seller will receive the quit claim deed. This way, closing on the property does not require you to chase down the seller nor can the seller change their mind at this point.
File a Performance Mortgage with the County Clerk
A performance mortgage (also known as a Deed of Trust) can be used to assure one party to a transaction to some kind of future performance by the other party (the party which allows a lien to be placed against their property). Yes, you do need the seller’s permission to file a performance mortgage with the county clerk, so be sure you make it a non-negotiable condition.
A performance mortgage secures you, the buyer (the Obligee) the performance of the lease option agreement by the (the Obligor). It gives you the same protection as if you had made a loan against the property (akin to a second mortgage). But make sure you have a bullet-proof “due on sale clause”.
In case of seller’s bankruptcy you are a secured creditor. Should another party attempt to foreclose, you have the right to cure the foreclosure and start a foreclosure proceeding all of your own. You can also foreclose out other liens and judgments should the seller lack funds to pay them off.
A performance mortgage will also prevent the seller from selling the property from under you and refinancing won’t happen without your permission.
If you have to pay outstanding HOA dues you have the right to be reimbursed by the seller. Same goes for property insurance (as the loss payee you will be notified of any lapse in insurance).
For details on the exact wording of any of these documents for your locality, seek qualified legal counsel before you even begin to negotiate.