As home prices continue to rise, those with their heart set on homeownership may be starting to explore less-traditional options to climb onto the property ladder. One such option is a rent-to-own agreement, a method of buying a house by renting it first. Here’s what you need to know.
- What are rent-to-own homes?
- How does rent-to-own work?
- Lease-option vs. lease-purchase
- Pros and cons of renting-to-own
- How to find rent-to-own homes
- Rent-to-own tips
- Alternatives to rent-to-own
- Is rent-to-own a good idea?
What are rent-to-own homes?
A rent-to-own home is one that allows for a tenant to rent the property, but also gives the tenant the option to buy it before the lease expires. Through rent-to-own, tenants can effectively test-drive a home, living in it for a period of time before they choose to buy it, while the owner of the home can use the purchase option to lock in a sale price, and also find a higher-quality tenant. If you’re the tenant, this can be a great way to find out if you like the neighborhood.
A typical rent-to-own arrangement has two parts: the rental lease agreement and the purchase option.
The lease agreement portion is like any other lease: It stipulates that you pay a set amount of rent on a regular basis while you live in and use the home, and sets conditions around that, such as what you can and can’t do to the property.
The purchase option gives you the right to buy the home during or at the end of your lease. The option spells out how the home’s price will be determined if you decide to purchase it (will it be set at the beginning of the lease or closer to expiration?) and how your rent payments could apply toward the purchase (if at all). You might need to pay an upfront fee to have this option included in the overall agreement, depending on the market.
How does rent-to-own work?
Rent-to-own is a way to buy a house by renting it first. In many arrangements, some of your monthly rent payment gets applied to the final purchase price. In effect, you’re making part of your down payment through your rent checks.
At the end of the rental period, you’ll have the option to buy the house, usually for a price agreed on in advance. At this point, you’ll need to get an acknowledgement from the owner regarding the payments you made and what will be applied to the purchase, then get a mortgage just like any other homebuyer.
“Rent-to-own can be extremely profitable for both parties, but it’s not for everyone,” says Martin Orefice, a real estate investor and owner of RenttoOwnLabs.com.
State laws vary on rent-to-own contracts, but typically, the deals can be set up any way the buyer/tenant and seller/landlord prefer. Both parties must agree on the purchase price, which can be tricky when the sale is happening several years in the future. In a rising market, for example, the seller might want the buyer to pay more than the current value of the property. Some contracts state that an appraiser will determine the price of the house at the time of purchase. If this is the case, the buyer/tenant should ensure the contract includes a right to hire their own appraiser, as well as a provision to address what happens if the buyer’s appraisal and the seller’s appraisal differ.
In addition, the contract should include whether the buyer is purchasing the home “as is” or if the seller will be responsible for any repairs or upgrades.
The buyer then pays an option as an upfront cost when signing the lease. The cost of that option can vary significantly, from 3 percent to more than 10 percent of the sale price, Orefice says.
Let’s say you enter a two-year rent-to-own agreement. The option fee is 5 percent of the home’s $150,000 purchase price, or $7,500. You’ll pay that amount upfront, and your monthly rent will be $1,500. Your lender will put 20 percent of the rent ($300) into an escrow account during the two years of your lease. You’ll then subtract the $7,500 option fee and $7,200 in rent credits ($300 over 24 months), which reduces the purchase price to $135,300.
A caveat about escrow: While the seller might offer up their attorney to handle escrow, it’s best to have your bank, lender or another third party manage the account, and require your and the seller’s signatures to access it. This can help safeguard the funds.
Lease-option vs. lease-purchase
Two different types of rent-to-own contracts are lease-option and lease-purchase agreements. Here are the obligations and penalties associated with each type.
When you sign a lease-option agreement, you pay an option fee to the homeowner so you can buy the home at the end of your lease term.
The lease will spell out what (if any) portion of the lease option or rent payment will go toward the purchase price. Remember, you can (and should) negotiate the option amount and monthly rent payments ahead of time. In most cases, your option fee goes toward reducing the purchase price of the property.
You’ll pay rent during your lease period, and any rent money you save during that time goes toward your down payment once you decide to buy the home. You’ll work with the seller to agree on a purchase price after your lease expires.
This is an ideal option if you’re not absolutely sure in the beginning whether you want to buy the home. You can walk away from the option if you choose not to buy the property, but the downside is that you’ll give up the option fee and your rent credits.
A lease-purchase agreement is very similar to a lease-option agreement. You still put a certain percentage of your rent payments toward a down payment to buy the home. The difference is that you and the seller agree to a purchase price ahead of time with a lease-purchase agreement. You can both agree to a price before you sign a lease agreement, or specify a date for an appraisal and decide on a price after the appraisal is completed.
You have an obligation to buy the home at the end of the lease when you enter a lease-purchase agreement. It’s a good idea to make sure you’ll qualify for a loan during your lease period because you’ll give up your claim to the home and all of the rent credit you’ve accumulated if you fail to qualify for a mortgage at the end of the lease. The homeowner can also sue you for breach of contract if you don’t buy the home.
Pros and cons of renting-to-own
Rent-to-own homes have pros and cons for both the tenant/buyer and the landlord/seller.
- Rent-to-own agreements could provide you with a path to homeownership if you can’t immediately qualify for a mortgage.
- If you fall in love with a specific home on the market, rent-to-own ensures no one else can purchase it.
- Rent-to-own can help you try out a new neighborhood before committing to a purchase.
- Rent-to-own can cut down on the cost and hassle of moving multiple times.
- If you don’t ultimately qualify for a mortgage, or miss a rent payment and nullify the contract, you’ll lose the money you spent on the option and potentially on above-market rent.
- The house could lose value over the lease period.
- Rent-to-own agreements can attract higher-quality tenants, who likely will also have an interest in maintaining the property.
- You can collect above-market rent each month, and potentially get a higher sale price when the buyer purchases the property.
- The tenant could decide not to buy the home, leaving you to find another tenant or start the sale process over again.
- Rent-to-own can take time, potentially a few years, which can be a downside if you need money now.
- You’ll need to vet prospective tenants thoroughly, which also takes time.
- The tenant could uncover defects with the property (which are easier to find while living in it) and demand a lower purchase price as a result. In the same vein, the tenant could damage the home or otherwise cause issues on the premises that could create headaches for you as their landlord.
How to find rent-to-own homes
Rent-to-own opportunities aren’t that common, but they’re out there. On Orefice’s RenttoOwnLabs.com, you can search for rent-to-own properties in your area.
You can also go the more traditional route, albeit with more legwork. First, find rentals on any listings website, and earmark those you’re interested in that also have a history of being on and off the market. This could represent a landlord who’s looking to offload their property but hasn’t had luck, and might be more willing to agree to a rent-to-own arrangement. An experienced real estate agent can help you with contacting the landlord and presenting an offer, or you can communicate with the landlord directly to gauge their interest.
- Choose the best terms for your situation – Be sure to weigh the pros and cons of both a lease-option and lease-purchase arrangement. If you’re not sure if you want to buy the home, a lease-option might be the better choice.
- Consult with a real estate attorney – When you’re ready to move forward, consider hiring a lawyer to examine the contract. Among the provisions, it should clearly spell out when rent is due; what, if any, portion of the rent will go toward the home purchase; whether the purchase is truly an option or an ironclad requirement; what appliances come with the sale if you do buy; and who performs and pays for repairs and maintenance during the lease period.
- Don’t just gloss over the contract – Read everything thoroughly, including deadlines and obligations. Learn about the option fee and rent payments, purchase price and how to exercise your intent to buy, as well as pet policies, maintenance details, property taxes and homeowners association fees.
- Get a home inspection – Have a home inspector check out the home before you agree to the purchase price, and ask the owner to pay for it. An inspector can identify major flaws with a home that will be costly to repair later on, and also protect you against claims for damages if you don’t buy, so this is an important step.
Alternatives to rent-to-own
Rent-to-own is a good option for some people who want to buy a home but aren’t quite financially ready, but it isn’t a one-size-fits-all solution. Here are some alternatives:
1. See if you qualify for a low-down payment mortgage
Traditional advice is that homebuyers should aim for a 20 percent down payment. This can make your offer more competitive and cuts out the cost of private mortgage insurance, but it’s still a substantial amount, and there are mortgage options that allow for much less. Some conventional loans allow for 3 percent or 5 percent down with good credit, for example, while FHA loans allow those with less-favorable credit to put just 3.5 percent down.
While a smaller down payment means a larger monthly mortgage payment (and borrowing more overall), it can be another option to get you into a home sooner.
2. Consider owner financing
Owner financing is an arrangement in which the buyer does not have to secure a mortgage. Instead, the buyer makes a down payment to the seller and signs a promissory note agreeing to make regular payments to the seller until they’ve paid the remainder of the home’s price plus interest. In effect, the seller is making a loan directly to the buyer. This can be a cheaper and faster way to get into a home, but be aware: The seller could charge a higher interest rate, impose a shorter loan term or both, and also charge a higher price in exchange for the loan.
The drawback for the seller, of course, is that the buyer could fail to make payments. If the seller still has a mortgage on the home and fails to make their mortgage payments because of this, the lender could foreclose on the home, leaving both the buyer and seller out of luck.
3. Practice patience
Possibly the least satisfying answer to this question, but still a viable one, is patience. Spend a year or two saving as much money as you can, and you might find yourself able to qualify for a mortgage and afford buying a home more easily.
Bottom line: Is rent-to-own a good idea?
Rent-to-own agreements might make sense for buyers who are certain that they’ll qualify for a mortgage and can keep the lease limited to a shorter period of time. This can be an ideal path for those who are on track to pay down other debt and improve their credit scores, or those who need to wait until they have a longer employment history to qualify for a mortgage.
Still, purchasing a home through a rent-to-own arrangement comes with risks and expenses that you probably wouldn’t have in a traditional home purchase.
“A lot of times, rent-to-own doesn’t lead to purchasing a home,” notes Sarah Bolling Mancini, an attorney with the National Consumer Law Center. “It can lead to losing wealth that you otherwise could have put toward the purchase of a home.”