How does rent-to-own work?
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In a highly competitive and quickly changing housing market, those with their hearts 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 everything you need to know.
What are rent-to-own homes?
A rent-to-own home is one that allows for a tenant to lease the property, along with 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 whether to buy it. This can be a great way to find out if you like the neighborhood as well as the residence itslef. The owner of the home, meanwhile, can use the purchase option to lock in a sale price, while also enjoying income from a high-quality tenant.
A typical rent-to-own arrangement has two parts: the rental lease agreement and the purchase option.
The lease agreement portion is much 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 it 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, either during or at the end of your lease. The option spells out how the home’s price will be determined if and when you decide to purchase it (will it be set at the beginning of the lease or closer to expiration?) and how your rent payments may 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 toward 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-upon in advance. At this point, you’ll need to get an acknowledgement from the owner regarding the payments you’ve made and what will be applied to the purchase. Then (unless you’ve lots of cash) you get a mortgage, just like any other homebuyer.
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 repairs or upgrades.
The buyer/tenant then pays for an option as an upfront cost when signing the lease. The option fee typically ranges from 1 percent to 5 percent of the total purchase price.
Then, each month, the buyer/tenant makes a payment. A designated percentage of it is called the rent credit. The homeowner/landlord will put your rent credit into an escrow account to be applied to your down payment later.
For example, 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 per month) into an escrow account during the two years of your lease. When it comes time to purchase, you’ll subtract the $7,500 option fee and $7,200 in rent credits ($300 over 24 months), which reduces the purchase price by $14,700, to $135,300.
A caveat about escrow: While the seller might offer up their attorney to handle the details, it’s best to have your own 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.
What to do while you rent
It’s also worth noting that you should be working toward getting approved for a mortgage during your rental period. If you aren’t approved for financing, you won’t be able to complete the purchase, unless you can afford to pay cash.
Most importantly, you should work on improving your credit score and building a solid credit history. If you have existing debt, try to pay it down aggressively before you apply for a mortgage. These measures help you get approved for a loan and may allow you to get better terms, such as a lower interest rate.
Are you an ideal rent-to-own candidate?
“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 Orlando, Florida-based Rent to Own Labs.
Renting to own can be a good option for people who want to buy a house but are financially unable to at the moment. It’s best for those who:
- Plan to stay put for awhile
- Don’t quite have enough for a down payment right now but are working their way toward it
- Have a credit score that’s too low to qualify for a mortgage currently
- Are able to afford a larger monthly rent than they may pay elsewhere
A rent-to-own payment is larger than a standard rent payment in your area, because you are paying that extra amount — the rent credit — on top of the regular rent. While you have to pay more now, if your home purchase closes your increased payments will turn into an investment.
Lease-option vs. lease-purchase
Rent-to-own contracts come in two basic kinds: 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 a portion of that rent money typically 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, because you can walk away from the option if you choose not to purchase the property. But the downside is that you’ll give up the option fee and your rent credit.
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. One difference with this type of agreement is that you and the seller agree to a purchase price ahead of time. You can both agree to a price before you sign a lease agreement, or specify a date for a home appraisal and decide on a price after the appraisal is completed.
Another crucial difference: When you enter a lease-purchase agreement, you have an obligation to buy the home at the end of the lease. 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 benefits and drawbacks for both the tenant/buyer and the landlord/seller.
- Rent-to-own agreements can 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.
- You will usually have to pay a premium rent rate instead of a market rent rate (because it includes the rent credit money put towards your ultimate purchase).
- You may have to pay non-refundable fees — such as an option fee — that you won’t get back if you decide not to buy.
- If you don’t ultimately qualify for a mortgage, or nullify the contract by missing a rent payment, you’ll also lose the money you spent on the option and potentially the rent credit as well.
- The home 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 takes time, potentially several years, which can be a downside if you need money now, or if home values fall in the future.
- You’ll need to vet prospective tenants very thoroughly — as you would a prospective buyer, rather than just a renter.
- 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 are not as common as traditional rentals or sales, but they are out there. Your best bet is to use a rent-to-own company to find properties with owners looking specifically for tenant-buyers. Here are a few reputable options:
Rent to Own Labs
Orefice’s Rent to Own Labs compiles listings from all over the country that are available for rent-to-own agreements. You can search by area, and each listing compiles the key stats about the property and its location.
Home Partners of America
With Home Partners, you find a home you’re interested in and they put in a cash offer to buy it. If the purchase is successful, you sign a one-year rental lease, which can be extended to up to five years at a locked-in rent price. You can decide to purchase the home at any time or walk away at the end of your rental agreement with no penalties.
Like Home Partners, Divvy helps you look for a home. If you qualify for the program, they purchase the home you choose and set aside a portion of your rent to put toward your eventual purchase. Divvy aims to help you qualify for a mortgage within three years.
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 whether you’ll 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 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 possible homeowners association fees. Make sure you know who is responsible for repairs and maintenance — in some rent-to-own contracts, the renter may be responsible from the start of the rental agreement.
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 the inspection. An inspector can identify any 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.
What happens after I move into a rent-to-own property?
Once you’ve decided to move forward with a rent-to-own property, what happens? You move into your home as a renter — but depending on your agreement, you may have to follow different rules than a typical renter.
Be sure to familiarize yourself with your contract. Some agreements may designate the tenant to be in charge of managing repairs and maintenance, as an owner would. (In some states, though, this is illegal.) In addition, make sure you understand the penalties of a late payment. If you miss a rent payment one month, or even if you’re late on a payment, this could be grounds for the owner to terminate your contract.
Typically, when your rent-to-own lease ends, you will either have the option of buying the house or be contractually required to buy the house. Either way, make sure you start working to secure a mortgage well in advance.
Alternatives to rent-to-own
Rent-to-own isn’t a one-size-fits-all solution. If you really want to buy but just need a leg up financially, here are some alternatives:
1. See if you qualify for a low down payment mortgage
Traditional advice states that homebuyers should aim for a 20 percent down payment. This can make your offer more competitive and eliminates the need for 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 can require just 3.5 percent down.
Remember, a smaller down payment means a larger monthly mortgage payment (and borrowing more overall). But it can be a good 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 directly 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 may 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.
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 short 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,” says 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.”
Whether renting or owning a home is cheaper depends on many factors. You need to consider home prices and rent prices in your area, plus the overall cost of living. Owning a home also means you are building equity, whereas when you rent, you aren’t investing in anything long-term. Bankrate’s Rent vs. Buy Calculator can help you crunch the numbers. In addition, you can use the Mortgage Calculator to help you determine how much a mortgage on a home in your price range would cost each month.
When you buy a home, you become the homeowner as soon as you close the sale. Buying a home outright typically requires that you have a lump sum of money to use for a down payment. With rent-to-own, homeownership is delayed. You pay rent for a certain amount of time before buying, with a portion of your rent being set aside monthly to go toward your down payment. You typically have to pay an option fee to the landlord in advance. At the end of your rental agreement, you can either decide to buy the house or not, but you don’t become a homeowner until you complete the purchase.
Rent-to-own may be a good option for those with low credit scores, because it gives you time to work toward improving your score before you need to apply for a mortgage. If you don’t qualify for a mortgage right now, you can use a rent-to-own agreement to start working on buying a house sooner rather than later.
If you don’t qualify for a loan, and can’t buy the home, you could be considered in breach of contract. At best, you will lose your option fee and any rental credit you’ve accumulated over the course of your lease.
These terms are typically used interchangeably. Technically, a lease typically refers to a longer arrangement, while rentals are generally short-term contracts for under a year. Still, sellers are likely to use rent-to-own and lease-to-own to mean the same thing. Just make sure you read the contract to understand if and when you’re responsible for purchasing the home.
Additional reporting by Lara Vukelich