When my husband was transferred to San Diego in the early 1980s, we knew someone selling a house and entered into a two-year, rent-to-own agreement.
In a rent-to-own, the owner promises to sell the property to the tenant within a certain time frame and price. Typically, a portion of the rent paid each month goes toward the purchase price or the buyer’s closing costs.
These deals are more common in slow real estate markets when it’s difficult for homeowners to sell outright. They lose appeal in seller’s markets, because they involve increased risk – the tenant may not qualify at the end of the lease period for a mortgage, or may trash the property and leave.
In our case, though, everything worked out. We loved the house and neighborhood and closed right on time.
Renting-to-own allows tenants to “test drive” a house and neighborhood while accumulating their down payment.
The agreement stipulates how much of the monthly rent will become rent credits – to be applied to the purchase price. If the home price is $200,000, the landlord may agree to apply 30% of the $1,500 monthly rent as rent credit. At the end of a two-year lease, the rent credit in this case would lower the purchase price of the home to $189,800.
The tenant builds equity in the home each month, although they will be paying fairly high rent. Renting-to-own also benefits the seller since any potential capital gains taxes are mostly deferred if the property is an investment property.
How Rent-to-Own Works
The agreement spells out who’s responsible for what, the lease term, and other variables, so read it carefully and consider asking a real estate attorney to review it, too.
You’ll also want to talk with a lender before entering into the agreement to find out what you’ll need to qualify for the loan down the road and get an appraisal and inspection. For you to get a mortgage on the home, the lender will have to agree that the base rent was the fair market value and that the option fee you’re paying was actually extra. This is important because if the lender believes the fair market value was higher, then you won’t be able to use that “extra” money for the down payment.
The fair market rent will be determined for the lender by an independent appraiser.
What’s an Option Fee?
Some rent-to-own agreements include an option to purchase, which means you’ll pay an “option fee,” usually 2 – 7% of the purchase price, for the right to purchase the property at a later date.
If the tenant exercises that option, the seller must sell the property to the tenant and apply the option fee to the purchase price. If the tenant chooses not to exercise that option, they’ll forfeit the option money.
Other rent-to-own contracts include an agreement to purchase. This means both parties have agreed on a purchase price, or that the purchase price will be determined with a future appraisal.
This is the type of agreement we had in San Diego, which was fortunate because the housing market there was cool at the time and the home we were renting appraised for less. We met with the owner and agreed on a new price.
Which option you choose depends on the market where you are renting. In a rising market, a fixed price will allow you to have equity in the home even before making the purchase. In all other market conditions, an appraisal at the time of purchase will ensure you don’t pay more than market value.
Who Pays for Repairs?
The rent-to-own agreement should cover who is responsible for maintenance and repairs.
Often the tenant will pay for small repairs and regular upkeep while large repairs like a leaking roof or structural damage are the landlord’s responsibility.
Under most rent-to-own agreements, you will lose your monthly rent credit if you pay the rent late – even by a single day.
And even if you’re current with your payments, if the landlord doesn’t pay the mortgage, property taxes and insurance payments on the home, it could turn into a foreclosure and you might be evicted.
What Sellers Should Know
As a homeowner, you have a lot of money invested in your property and you’ll want tenants who will take good care of your home. You should find out all you can about your prospective tenants and review their credit report.
Under the contract, you should have the right to collect a deposit and first and last month’s rent, and the right to evict your tenant if the rent is not paid.
What Tenants Should Know
If you’re considering a rent-to-own agreement, be sure your credit score will be high enough to qualify for a mortgage by the time the lease expires.
If you cannot qualify for a home loan once your lease-to-own agreement is up, you’ll forfeit all of your equity.
What Happens at Lease-End?
The tenant can buy the home when the lease ends or earlier if they so choose. If they decide to move forward with the purchase, they’ll work with their lender to qualify for a mortgage that covers the remaining purchase price of the property.
If the tenant decides not to buy the home, the owner keeps all of the money paid during the lease, including any upfront option fee. The owner could put the house back on the market or find new tenants.
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