How does rent-to-own work?

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As home prices continue to rise, those with their heart set on homeownership may be starting to explore less-traditional options to climbing onto the property ladder.

One such option is a rent-to-own agreement. But going this route can be more complicated than it sounds. Here’s what you need to know about how rent-to-own works:

How does rent-to-own work?

Rent-to-own is a way to buy a house by renting it first for a few years. Some of your monthly rent payments get 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 that point, you’ll need to get a mortgage just like any other homebuyer.

“Rent-to-own can be extremely profitable for both parties,” says Martin Orefice, a real estate investor and owner of RenttoOwnLabs.com. “But it’s not for everyone.”

State laws vary on rent-to-own contracts but, typically, the deals can be set up any way the buyer and seller would like. 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 may 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.

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. The lease will spell out what (if any) portion of the lease option or the rent will go toward the purchase price. Remember, you can (and should) negotiate the option amount, the purchase price and monthly rent payments.

Pros of rent-to-own

A rent-to-own agreement could provide a path to homeownership for buyers who can’t immediately qualify for a mortgage. It’s also a way for buyers who fall in love with a specific house on the market to make sure that no one else can purchase it.

Buyers might use a rent-to-own contract to try out a new neighborhood before committing to a purchase, or they might want to lock in the price of a home when prices are going up. Another positive: Cutting down on the cost and hassle of multiple moves.

Cons of rent-to-own

The biggest risk of rent-to-own agreements is that the potential buyer pays the option and an above-market rent but then is unable to purchase the house. That could happen if the buyer is ultimately unable to qualify for a mortgage, or if they missed rent payments and nullified their contract. It’s also possible that the house could lose value over the rental period. 

Differences between 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. 

Lease-option

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 agreement. 

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. 

Lease-purchase

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.

Applying rent payments to the purchase price

Because you’ll apply a specific amount of money each month to the home’s purchase price, you should negotiate the amount upfront with your landlord. You’ll pay extra to rent the home beyond strictly rent. For example, a house that you’d normally rent for $1,000 a month might be $1,200 with a rent-to-own agreement, and the extra $200 would be saved as credit toward the home purchase.

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 ($300) into an escrow account during the two years of your lease.

You’ll subtract the $7,500 option fee and $7,200 in rent credits ($300 x 24 months), which reduces the purchase price to $135,300.

Before you sign the contract

Prior to signing the contract, it’s important that you do your due diligence. 

  • Choose the best terms for you: Decide whether you want a lease-option or lease-purchase agreement, and weigh the pros and cons of both options.
  • Don’t just gloss over the contract: Read everything thoroughly, including deadlines and obligations. Learn about the option fee and rent payments, purchase price, how to exercise your intent to buy and pet policies, as well as maintenance details, property taxes and homeowners association fees.  
  • Get a home inspection: Have a home inspector check out the house before you agree to the purchase price. A home inspector will identify major flaws with a home that will be costly to repair later on.

When you’re ready to move forward, consider hiring a real estate lawyer to examine the contract. It should clearly spell out the following:

  • When rent is due and what the penalties are for late payment
  • What, if any, portion of the rent will go toward the home purchase
  • Whether the purchase is truly an option or an ironclad requirement (a lease-option contract gives you the option to buy at a specific time, while a lease-purchase contract requires you to buy it)
  • What appliances come with the sale
  • Who performs and pays for repairs and maintenance during the rental period

Bottom line: Is rent-to-own a good idea?

Rent-to-own agreements may make sense for buyers who are certain that they’ll qualify for a mortgage and can keep the rental limit to a shorter period. 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.”

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