I am trying to purchase a home that I have been living in under a lease with option to buy contract.

If you can document the transaction carefully, lenders will fund this scenario. You MUST have the fully ratified lease-option contract. The money must be sitting in a separate account specifically for this purpose. The only money that will count towards your purchase is the money IN EXCESS of market rent that was paid monthly – the market rent does not count (though the seller could reduce your price to credit you, in theory). As you are buying the home you occupy, you must document at least 6 months of rent checks or transfers (cancelled checks, paid on time), and an appraiser must verify that the transaction is “arms length” – that is, not between parties that have a relationship outside of this transaction. The price must not exceed current market value (and shouldnt be much under it, either).

Lenders are VERY cautious of this set up due to the potential for fraud. A desperate seller may “gift” you the down payment just to get out, claiming it is actually a rent credit. A family member about to lose a house or needing to short-sell for less than the amount they own may attempt to sell the property to a family member or friend under the guise of vacating, but continue to occupy it (making the family a “straw” buyer). A seller may attempt to sell the home for MORE than it is worth, capitalizing on the ease of selling to a tenant that may have few other options. Buyers and Sellers may feign a lease-contract to conceal that the money is actuall a gift or loan from a third party, and not belonging to the buyer as indicated. All of these scenarios represent a degree of fraud, and are very risky to the lender.

BUT … if your contract is valid, the credit is only the money paid in excess of market rent and there is a paper trail available … you have been in the home for at least 6 months … and you otherwise qualify for the loan, you should be ok. Put your documents together carefully and approach a few local lenders for your options.

Since you mention 3.5% down, I assume you are looking for FHA financing (this is the product that generally requires that exact amount). More information about FHA underwriting guidelines can be found here:

http://portal.hud.gov/hudportal/HUD?src=/program_offices/housing/sfh/fharesourcectr

Lenders have their own overlays and requirements, but you should be able to find someone willing to honor these guidelines if you have all your ducks in a row.