How Does Rent-to-Own Work?

by | May 4, 2021 | Buying, Real Estate Glossary

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So you know that renting doesn’t allow you to build equity, but you aren’t sure you can afford a mortgage right now, this is when rent-to-own comes into play. Buyer and sellers can benefit from a rent-to-own agreement, but it’s essential that both parties fully understand what they are entering into. Let’s look at how rent-to-own works and who it works best for so you can decide if this is the right option for you.

What is it?

Oftentimes a buyer with limited credit or low income who cannot qualify for a mortgage will consider a rent-to-own home. A rent-to-own agreement allows the buyer to start the process of buying the home while building their credit score over time.

A rent-to-own home requires a specific agreement that allows you, the tenant, to buy the home after a set period of renting it. In this type of agreement, you will pay a slightly higher rent price than market value. This is because your rent payment includes funds contributing to your down payment. Your lease or rental agreement should detail your rental payment, how much of this amount goes toward your down payment, and what the purchase price of the home will be.

How it Works

Determine a Price

The buyer and seller must establish a purchase price for the home. The buyer will eventually purchase the home for this price, typically within 1-3 years of signing the agreement. The agreed upon price may be higher than current market value, due to accounting for projected increases in home value over the period of the agreement. It’s important to note here that the buyer will be expected to purchase the home for the agreed upon price, regardless of what the home is actually worth at that time.

Typically, buyers rely on a real estate agent to assist in determining a fair purchase price, but agents aren’t usually involved in rent-to-own transactions. However, advice is still essential, review your contract with an agent or attorney to ensure you are not losing money if things don’t go as planned.

Upfront Fees

As the buyer, you are responsible for paying the seller a one-time, option fee, also referred to as option money or option consideration. The option fee is negotiable, but is typically anywhere from 1 to 5 percent of the agreed upon purchase price. Keep in mind the fee is nonrefundable, but can be applied towards the purchase price of the home. 

Monthly Payment

Buyers in rent-to-own agreements pay higher than market value in rent. The amount paid in addition to your rent is credited towards the final purchase price of the home, thus reducing the amount you have to borrow for the purchase. The extra rent is non refundable, acting as compensation for the seller whose not to sell their home to anyone else.

Maintenance 

Usually, the landlord is responsible for repairs and any associated maintenance costs since they pay any HOA fees and insurance. However, you’ll want to review the agreement to ensure you understand your role in maintaining the property, whether it’s simply mowing the lawn, or if you could end up being responsible for replacing the roof.

You can also order an appraisal or have a home inspection done to ensure you know the condition of the home before agreeing to purchase it. This is also a good time to confirm there are no liens on the given property, and the property taxes are paid.

Types of Contracts

Rent-to-own home

Which type of agreement is better? This depends on the real estate market. If home prices are increasing, you can maximize your equity early on by locking down a purchase price. If home prices are stagnant or decreasing, waiting until you purchase the home to do an appraisal could save you thousands. 

Lease agreement with option to purchase 

A lease option provides the buyer the option to buy the home when the lease expires, but does not require you to make the purchase. Once your lease has expired, you can choose to walk away from the home without any obligation to buy. However, when you choose not to buy the home you forfeit the option fee and your rent payments towards the purchase price.

Lease agreement with purchase agreement

This agreement requires you to buy the home at the end of your rent-to-own lease. You will agree on a purchase price with the seller prior to signing the contract, or you can choose a specified date for an appraisal to determine a purchase price. Choosing this agreement means you should plan to search for a loan prior to your rent-to-own agreement coming to an end. If you’re unable to secure a mortgage prior to the end of the lease, the owner can sue for breach of contract, and you’ll lose all the money credited towards the purchase.

Rent-to-Own Pros

Avoid Buyers Remorse

Think of rent-to-own as an opportunity to “try it before you buy it” and avoid the possibility of buyers remorse. If you choose to sign a lease option, then you’re able to change your mind about the home and the maintenance that comes with it without investing quite as much. Rent-to-own is important to consider if you’re not completely sold on homeownership. However, it’s important to ensure that your monthly payment is on the low end if you think you may change your mind. 

Build Equity

Rent-to-own allows buyers to lock in their purchase price prior to the sale. The rent-to-own agreement should detail the agreed-upon purchase price of the home, this may be higher than current market value to accommodate the market changing over time. Ultimately, in a rising market, the locked in purchase price could help you begin to build equity before you even own the home. This is purchasing equity which isn’t quite the same as traditional equity, because you do not own the home yet. 

Move Less

Find a neighborhood you love and see what it’s like to live there before you commit to purchasing. Once you’re sure the home is what you’re looking for, lock in the purchase price and you’ve saved yourself the time and trouble of moving at the end of your lease. When your rental term ends, you have exclusive rights to purchase the home as the owner will not list their home unless you choose not to pursue the purchase agreement. 

Again, be sure you know what you stand to lose if you choose not to buy the home after signing a contract. 

Build your down payment over time

Traditional home purchases typically require the buyer to provide an earnest money deposit and be approved for a mortgage, if this is not a possibility for you then rent-to-own could be a great option for you. This agreement allows you to put money towards your down payment over an extended period of time, while providing the peace of mind that you’re living in a home you’ll eventually call your own. The bigger your down payment, the less your monthly mortgage payment will be.

Rent-to-own also allows you to live in a home prior to securing a mortgage. This is beneficial if you have other debts and are currently unable to qualify for a loan. 

Don’t worry about credit 

Many landlords accept lower credit scores than traditional lenders. Choosing to rent-to-own gives buyers time to build their credit, the higher your credit score, the better your mortgage interest rate. Consider adding a clause in your rent-to-own agreement requiring your landlord to report your monthly payments to the credit bureaus. This allows you to actively build your credit over the period of your lease.

Rent-to-Own Cons

Losing Money

In a rent-to-own agreement, you may lose the right to purchase if your rent payment is late or if you’re unable to secure a mortgage. You may also end up losing money if the market begins to decline and the value of the home decreases, causing you to ultimately overpay if you cannot renegotiate the purchase price. 

Depending which type of agreement you sign, if you choose not to buy the rent-to-own home, you stand to lose all the money you’ve invested throughout the period of your lease. 

Less Control

You live in the home but do not own it yet, so you are still relying on the landlord to stick to the contract. In some cases a landlord may stop making payments and lose the home to foreclosure, or fail to pay property taxes resulting in a lien on the property. It’s important to consult a real estate attorney to ensure your agreement includes provisions for each of these possibilities. 

Maintenance 

Treat a rent-to-own home as a traditional purchase and ensure you have a home inspection done. There may be structural issues or problems below the surface you can’t see that end up costing you thousands. Be sure to review your agreement and understand what maintenance tasks you are responsible for and their associated costs.

Find a Real Estate Expert

Rent-to-own can be a tempting alternative to a traditional home loan, but it is not for everyone. It is up to you as the buyer to evaluate your situation and weigh the pros and cons. Enlist the help of a real estate agent to help you evaluate the market and what the best option is for you.

Thinking About Buying Or Selling A Home?

Get the best real estate advice from local experts in your inbox.

Thinking about buying or selling a home?

Get the best real estate advice from local experts in your inbox.