How to Screen Lease Option Tenants

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How to spot potential lessee-buyers who have no chance of ever closing a purchase

 With fewer people in today’s marketplace able to obtain traditional mortgage financing for a home purchase, many sellers are stepping up to provide interim “seller financing” until their buyer can obtain a traditional mortgage. Commonly called a lease option or “rent to own” program, seller assisted home purchases allow buyers a place to call home, while providing some necessary time to get their finances and credit scores in order before seeking a traditional mortgage.

The main goal in choosing a lessee-buyer is to weed out those that have absolutely no hope in the world of obtaining bank financing, from those who can be financed with a few touch ups to their credit or financial situation. Nothing is worse for a seller than getting stuck with a lessee-buyer who can’t obtain a mortgage and complete the purchase. This article shows lease option sellers how to separate strong lessee-buyers who are capable of executing a purchase, from mere wannabes.

 The application gathers essential information

Because a traditional mortgage, obtained by the lessee-buyer, is the mechanism that cashes a lease-option seller out, it benefits both parties to put together the lessee-buyer’s personal and financial information that a bank or mortgage lender will need. This information should be used by the seller to select the best possible lessee-buyer and can be gathered on a seller provided lease option application; although the application process is best done by a mortgage broker who can instantly pull the prospective lessee-buyer’s credit report at the time of application, streamlining the entire buyer selection process. Mortgage brokers have the ability to screen a lessee-buyer’s probability of obtaining a mortgage in the near future and literally offer the best hope of selecting a solid lessee-buyer. If the application is administered by the seller however, it should include the following personal information from the lessee-buyer:

• Lessee-buyer’s full name, Social security number, Home/main phone number, Date of birth, Marital status, Number of dependents/ages
• Present address & Subject property (home to be purchased) address
• Complete two year residence history (own or rent) with landlord contact info if rented dwelling
• Source of down payment for this home purchase (borrower savings, gift, a fraction of each month’s lease payments going towards down payment etc.)

The lease option application should also contain the following employment information from the lessee-buyer:

• Name and address of current employer(s), Years on current job(s), Years employed in this particular line of work/profession, Position/title/type of business, Business/work phone, Supervisor’s name and phone number
• Complete two year work history if holding current job for less than two years. For each job, include the employment information asked for above for each employer.

Finally, the lease option application should include the borrower’s financial information, consisting of:

• Monthly base employment or self employed income
• Other monthly income: bonuses, overtime, commissions, dividends, interest, net rental income
• All monthly living expenses
• Bank account information, consisting of name and address of bank, savings and loan institution or credit union.
• Type of account(s) held (savings, checking, CD, money market etc.) and account numbers.
• List other assets (with their current market values) such as stocks, bonds, mutual funds or any valuable items that will be sold to fund the down payment for the purchase of the subject home.
• Liabilities such as credit card debts, auto loans, alimony, child support or judgments. Include account numbers, outstanding balances, minimum monthly payment amount and months left to pay.
• Purchase price of the subject home

 It is just as easy to have potential lessee-buyers to complete the very same application that all mortgage professionals use to pre-qualify prospective borrowers. Referred to as a Uniform Residential Loan Application (also called a 1003 Loan Application), this form will eventually need to be filled out by the lessee-buyer prior to obtaining a mortgage, so why not just have them do it right off the bat as a part of the screening process? A 1003 Loan Application can be handed right over to a mortgage broker who can determine the chances of an individual lessee-buyer obtaining a mortgage in a reasonable timeframe. Because mortgage brokers know current bank lending guidelines, they are a lifeline for lease option sellers who seek the best possible lessee-buyer. The information provided in the lease-option application, in combination with a signed Credit Authorization Form, which authorizes the seller or mortgage professional to pull the lessee-buyer’s credit report, will be all that’s needed for a mortgage broker to determine if the lessee-buyer is a waste of time or has a legitimate shot at obtaining a mortgage in the near future.

Download these useful forms:

Uniform Residential Loan Application

Credit Authorization Form

 Credit report

The main goal in having a potential lessee-buyer fill out an application and a borrower’s credit authorization form is to gain access to their credit history. Most mortgage lenders in today’s market generally require a home buyer to have two of their three credit scores above 620. Because most lessee-buyers will not have perfect credit at the time of application, it becomes imperative for lease option sellers to decide which potential lessee-buyers are hopeless from a credit standpoint and which ones have a reasonable shot at improving their credit to facilitate the home purchase at a later date.

A potential lessee-buyer should be cast aside if their credit report reveals outstanding tax liens that are too large to be paid off within a year, recent bankruptcy or foreclosure (today’s mortgage lenders will only close buyers who are at least three years removed from bankruptcy or foreclosure), judgments that are too large to be paid off immediately, large sum collections, and consumer credit charge offs or repossessions that are under three years old. High credit card balances that can’t be paid below 50% of their credit limits within a year also signify danger for sellers. An individual’s credit scores in the mid 500’s or lower are usually a result of one or more of the problems listed above. Clients in this credit score bracket should be cast aside in most cases, as raising scores that are this low could take years.

Potential lessee-buyers with credit scores in the high 500’s or low 600’s are generally in a position where their credit can be fixed in a few short months by paying off collections or credit card balances that are approaching their credit limits. Clients like this are often times optimal for lease option sellers to work with because they are very close to obtaining a mortgage from a credit standpoint. It’s important to know that most mortgage professionals are wizards when it comes to helping individuals raise their credit scores. With some guidance from a seasoned mortgage professional along with diligence on the lessee-buyer’s behalf, qualifying for a mortgage may be right around the corner.

“What If” Reports

A tremendously useful tool for both buyer and seller is a What If Report. Commonly called a Credit Score Simulator, a What If Report is a personalized step by step guide, generated by credit reporting agencies, which shows a potential borrower what actions to take to improve their credit scores. Best handled through a mortgage broker, a credit score simulator can help determine if a lessee-buyer has the potential to obtain a mortgage by doing various things such as paying down current credit card debts, judgments or collections. Many consumer accessible credit report vendors also offer this service.

Most helpful is that actual score increases are shown through these simulators and matched to the various actions a potential borrower can opt to take. For example, a credit score simulator shows that a potential borrower has a $900 collection that, if paid off, will increase their three credit scores an average of 20 points. The simulator also shows the potential borrower has a $1,500 credit card balance. By paying the credit card balance down by $751, the borrower’s three credit scores will jump up an average of 40 points. Using the information generated by the simulator, the potential borrower can decide which actions to take that will impact their scores the most, and learn how much each action will cost. In this example, it is actually cheaper to pay down the credit card by $751 than it is to pay the $900 collection off. Choosing to pay down the credit card also bumps their credit scores 20 points higher than choosing to pay the more expensive collection off. If the borrower can afford to pay down both of these debts, a whopping 60 point increase in credit scores would be realized. That’s the power of this insightful credit enhancement tool. It’s a crystal ball at your fingertips and can be used to help close a lease option buyer by raising their credit scores to levels that mortgage lenders will work with.

Income

In order to obtain a mortgage, a lessee-buyer needs to show mortgage lenders that they make enough money to afford the home they hope to buy. Generally mortgage lenders deem a home “affordable” if a buyer’s debt to income (DTI) ratio is under 45%. A copy of the prospective buyer’s credit report and last 2 year’s W-2’s or income taxes are required to calculate a buyer’s debt to income ratio, which is done by following the steps below:

• Determine the proposed mortgage payment, including property taxes, homeowner’s insurance, and private mortgage insurance (PMI) – which is required if the proposed mortgage exceeds 80% of the home’s purchase price. The proposed mortgage payment hinges on the purchase price of the home, current interest rates and the size of the lessee-buyer’s anticipated down payment. For example, a $200,000 purchase price with a $20,000 down payment will require a $185,000 mortgage (factoring $5,000 in closing costs set aside from the down payment). A mortgage professional can help quote an estimated interest rate based on the applicant’s credit scores. For this example, let’s use an interest rate of 7%. A $185,000 mortgage at 7% interest amortized over 30 years is $1,230.81. PMI for this mortgage is $144.92. If homeowner’s insurance is $100 per month and property taxes are $400 per month, then the total proposed mortgage payment is $1,875.73.
• Add the proposed mortgage payment to all of the monthly debt obligations currently listed on the lease option applicant’s credit report. In this example, let’s assume that the prospective lessee-buyer has a $250 monthly car payment, a $200 minimum credit card payment and another minimum credit card payment of $75 per month. These minimum monthly debt obligations total out to be $525 per month. Remember that other monthly obligations such as child support, alimony or a money judgment needs to be factored into a loan candidate’s debt obligations as well.
• Next, add the total proposed mortgage payment of $1,875.73 to the prospective buyer’s minimum monthly debt obligations of $525, listed on their credit report. The buyer’s total monthly debt obligations in this example would be $2,400.73.
• Calculate the mortgage candidate’s monthly income. Mortgage lenders use a monthly average of a borrower’s 2 year combined income, usually evidenced by their W-2 earnings statements or tax returns. In this example, the prospective borrower made $58,750 in 2008 and $62,200 in 2009. If we add these two figures together and divide by 24 months, we get an average two year income of $5,039.58. Please note that other income sources such as alimony or child support should be factored into a loan candidate’s income. Doing so helps build a stronger loan file, increasing the chances of the deal closing.
• Finally, divide all monthly debt obligations by the mortgage candidate’s average monthly income over the past 24 months, then multiply this figure by 100 to get the borrower’s DTI ratio expressed as a percentage.

In this example, our borrower cannot afford the subject home because they have a DTI ratio of 47.6%; this is 2.6% higher than the 45% DTI ratio that most mortgage providers look for. In order to afford this home, the prospective buyer would need a co-borrower with an established monthly income to raise the DTI, or the borrower would need to get another job to increase their income. The safe play is for the seller to look for another prospective lessee-buyer who has a lower DTI ratio and can afford this home.

A seller can easily prequalify a lessee-buyer based on their income by following the procedure above. It’s imperative to collect the very same information lenders will want, consisting of the buyer’s credit report showing their monthly debt obligations, and the borrower’s last 2 pay stubs, income tax returns or W-2’s over the past two years. These documents are the basis for calculating a consumer’s DTI ratio.

Bank statements prove down payment source and reserve requirements

Before closing a loan for any borrower, lenders want to see the monetary equivalent of a down payment and several months (usually 3-6 months) worth of mortgage payments set aside. These funds need to be “seasoned” for 60-90 days or more. In other words, the funds need to be in the prospective borrower’s possession for a minimum of 60-90 days, as evidenced by 2-3 month’s bank statements. For a lease option transaction, the seller should request the lessee-buyer candidate’s last three month’s bank statements to verify their liquidity. Examining these bank statements will indicate if the lessee-buyer lives hand to mouth or that they have enough money saved up to afford a down payment and several month’s worth of mortgage payments should their income suddenly stop. If a lessee-buyer has the money in a 401K, CD, money market, IRA or other type of investment vehicle, this will suffice. These documents will need to be gathered and filed by the seller.

A lease-option seller and buyer can get around the down payment seasoning requirement set forth by the eventual mortgage provider because a wise lease option seller will require a minimum 5% nonrefundable down payment from the buyer prior to move-in. Most current mortgage lenders require a minimum 3.5%-5% down payment, shown seasoned within a buyer’s bank account for 60-90 days. Since the lessee-buyer will have already paid the down payment to the seller (thus creating equity within the house) the lender’s down payment requirement will be satisfied. It is wise for lease option sellers and buyers to make sure the down payment is documented within the lease agreement, a copy of the down payment check is kept and a receipt is given to the buyer, with the seller keeping a copy of this receipt as well. Note however, that the lessee-buyer will still have to show an eventual mortgage lender several month’s worth of mortgage payments set aside in their checking or savings account before obtaining a mortgage.

For potential lessee buyers who do not have a down payment, or only have a partial down payment, a seller can accept a set amount from the monthly lease payment to go towards the home’s down payment. An installment down payment like this needs to be written as a clause within the lease agreement and shown to the eventual mortgage lender at the time of application. An installment down payment makes it easier for the buyer to obtain financing for the final purchase without having to save a lump sum or show lenders where their down payment came from via bank statements. The danger for sellers is that the lessee-buyer would have an incentive to dodge their monthly lease payments by not putting much up to occupy the home. Low down payment scenarios like this often leave sellers with a vacated or damaged home and not enough collected from the buyer up front to pay for the damages.

Cover your ass-et

A large nonrefundable down payment can act like an insurance policy for sellers. Many lessee-buyers, who are only required to pay a small down payment to the seller, have little incentive to complete the deal and can walk away from the subject house at any time, leaving tremendous financial damage to the seller. Some lessee-buyers will leave a home without giving prior notice to the seller, opening the door for vandalism of a now unoccupied house. Spiteful tenants will trash a house so that the seller suffers a financial loss on a house. To protect themselves, lease option sellers should always make sure to collect a down payment from the lessee-buyer that would cover the cost of a minor renovation, including drywall repairs, a full interior paint job, a furnace, new plumbing with hot water tank, kitchen cabinets, damaged window glass, light fixtures and new flooring. The minimum allowable non-refundable down payment should be $5,000, or 5% of the appraised value of the house, whichever is greater. The down payment should always be non-refundable because this is another way to be sure your lessee-buyer is serious about actually cashing you out later on. Buyers who aren’t serious usually aren’t willing to put up so much money, therefore the down payment also serves as a good buyer screening mechanism.

Should there be any damage to the seller’s home or if the lessee-buyer skips payments, the seller will want to collect damages from the lessee-buyer. Without sufficient income or provable job status, it may be hard for a seller to collect; therefore not only does properly screening potential lessee-buyers help determine which ones have the ability to execute a final purchase, but which ones can be collected from as well.

Job history

Mortgage lenders want to see that a potential borrower has a 2 year continuous job history with no gaps in employment. A potential lessee-buyer that was not working for a period of time and just got a new job will have to wait until a 2 year job status is reached before obtaining financing in most cases. This is a general rule of thumb. Sometimes a lender will allow a recent college graduate who may have been working an internship or only has 6 months working at their new job to receive home financing. In other cases, a gap in employment may be overlooked by a lender if the potential borrower switched jobs but stayed in the same profession. A lease option seller can approve an applicant with a continuous work history shorter than two years, but in most cases a seller will have to wait until a two consecutive year job status is reached. Self employed lessee-buyers will need to show that their corporation is at least two years old through tax returns and corporate filings before obtaining a mortgage.

Residence History

Mortgage providers look for a potential borrower’s two year residence history, consisting of at least two consecutive year’s on time rent or mortgage payments. Cancelled checks going towards rent or a mortgage is usually the proof the lender will want from a potential borrower. Remember that a potential lessee-buyer will be creating a residence history with the lease option seller. This means that for a potential lessee-buyer that has good credit, sufficient income (<45% DTI ratio with proposed housing expense), a two year continuous job history, but has only one year paying a housing expense, is a good candidate to close a lease option purchase provided the seller and lessee-buyer can show proof of on time lease payments to a mortgage lender at the end of one year. In fact, a buyer like this is optimal to lease a house to. A seller should call the former landlord and ask for cancelled housing expense checks to verify

Sometimes a younger borrower can obtain a mortgage with no residence history at all. This usually occurs in a situation where the borrower has good credit, sufficient income to afford the subject home, 2+ years in the same line of work, but has lived with their parents and is moving out for the first time. A mortgage professional knows which lenders will accept a potential borrower like this as this particular borrower guideline

Great tips for lease option sellers

• Form a good relationship with a reputable mortgage professional, preferably a mortgage broker. Have your potential lessee-buyers apply for a mortgage through your selected mortgage broker, who can evaluate each potential lessee-buyer’s “mortgage worthiness”. Often times, a good mortgage professional can literally spell out the exact steps a loan candidate will need to be able to achieve a mortgage.
• Develop a checklist with the help of your selected mortgage broker to see what actions are necessary to qualify your buyer for a mortgage. Lessee buyers obviously lack certain criteria to obtain a mortgage right away, that’s why they must lease or rent before owning. Pick the best lessee-buyer candidate by determining which checklist contains the most feasible actions to complete in a timely fashion.
• Borrowers capable of obtaining a mortgage have the following: 620+ credit scores with no tax liens or debts/judgments too large to be paid off within a year, no foreclosures or bankruptcies within two years, >2 continuous year job history, >2 year residence history (provable with on time cancelled rent checks), >2 months bank statements (or other investment vehicle statements) with 2-6 months worth of reserves set aside, and a <45% DTI ratio. Lease option buyers who have a DTI ratio above 45%, or those that have massive credit problems should be cast aside immediately.
• What If Reports are a great way to see what actions will be necessary to improve a client’s credit scores, helping sellers pick the lessee-buyer most likely to obtain a mortgage by improving their credit.
• Have an attorney draw up the lease option documents. Always work through an attorney when it comes to structuring agreements and turning over possession of a house to someone else. It may be worth looking into for your attorney to draw up a performance clause within the lease option agreement, placing pressure on the lessee-buyer to improve their credit by a certain date etc.
• For some lease option sellers, it may be beneficial to sell a home on a land contract versus a lease option. Lease Option Magicians is an article which details tricks that experienced lease option sellers use to close their deals faster. Sometimes, selling on a land contract can pose huge advantages over selling through a lease option.
• President Ronald Reagan was famous for saying “trust, but verify”. This is the best advice for a lease option seller who should listen to their buyer-applicants, but also verify everything from a buyer applicant that a mortgage lender will scour for in the end.
• The most threatening lease option “deal killer” is a buyer’s debt to income ratio. Any buyer with a >45% DTI ratio is usually a dead end unless a spouse with income is used as a co-borrower.
• Lease option buyers who have the ability to cash a seller out but have poor credit need to have their credit scores evaluated by a mortgage professional. Usually two of three credit scores above 550 can be brought up to a decent level in a reasonable timeframe.