Rent-To-Own Homes: A Complete Guide
When buying a home, you typically need a good credit score and a down payment to qualify for a mortgage. But what if you have credit issues, limited savings or are struggling with debt?
For prospective buyers trying to decide between renting or buying a home, one option to consider is a rent-to-own home. A rent-to-own home can bridge the gap between renting a property and buying it. It’s essential to understand the process, rewards and potential risks.
What Is A Rent-To-Own Home?
With a rent-to-own home – also called a lease-to-own-home – you sign a lease agreement that usually lasts 1 – 5 years. A portion of your monthly rent payment goes toward reducing the home’s sales price. You can purchase the home for the remaining purchase price at the end of the lease term.
When Would A Homeowner Agree To A Rent-To-Own Agreement?
Rent-to-own agreements are more common in slow real estate markets where homeowners are having a tough time selling homes. But, in hot seller’s markets, lease-to-own agreements lose their appeal for homeowners.
How Does Rent-To-Own Work?
Rent-to-own agreements start when a buyer and a homeowner formally agree the buyer can rent the property for a given period. Depending on the agreement, the buyer is required to purchase the property at the end of the lease term or has the option to buy the property.
Buyers who enter into rent-to-own agreements pay a one-time premium – sometimes called an option fee – on top of rent. The premium contributes to the down payment and is usually nonrefundable. The fee adds a financial incentive for renters who feel confident about buying the property at the end of the lease agreement.
Lease Option Vs. Lease Purchase
You’ll find two main lease types with rent-to-own contracts: lease options and lease purchases.
A lease option offers the choice to buy the home at the end of the lease. You aren’t legally obligated to buy the home. But, if you walk away from the property, you’ll lose all the money you paid toward the home’s purchase price and the option fee.
A lease purchase means you’re legally obligated to buy the home at the end of the lease. With a lease purchase agreement, owners minimize the risk of a renter walking away at the end of the agreement and give renters a stronger incentive to maintain the property.
It’s important to understand the terms of your contract before signing it. Have a real estate attorney review the contract and answer any questions. You should also speak to a mortgage lender to confirm that you can meet loan requirements when it’s time to buy the home.
Rent-To-Own Pros And Cons
As with any big decision, you should weigh all the pros and cons. Depending on each party’s situation and financial goals, rent-to-own can work for home buyers and sellers.
Pros For Home Buyers
A rent-to-own agreement can have the following advantages:
- More accessible: A rent-to-own agreement offers buyers struggling to qualify for a standard mortgage loan an avenue to homeownership.
- Build credit: During the lease period, potential home buyers have time to build their credit, reduce their debt, boost their income or take other steps to make their loan application more attractive to mortgage lenders.
- Fixed purchase price: You lock in the purchase price at the beginning of the rental period, which is helpful, especially if home prices are climbing.
- Build equity: Many rent-to-own agreements allow renters to build home equity while leasing, either through the option fee, which acts as a down payment credit, or the portion of the monthly rent payment applied to the home's purchase price.
Cons For Home Buyers
Rent-to-buy has some disadvantages.
- Sunken costs: If you don’t buy the home, you’ll lose the option fee and have no home to show for your upfront investment.
- Decline in market value: You pay the seller the agreed sale price, even if the home loses value during the rental period. If you agreed to buy the home for $200,000, that’s the price you’re obligated to pay even if the home’s value declines to $170,000.
- Hidden problems: There may be problems with the home you aren’t aware of until you’re ready to buy. The seller may have title issues or isn’t the property’s rightful owner. A home appraiser may discover problems that prevent a lender from approving the mortgage loan, or a home inspection may reveal expensive defects or issues.
Pros For Home Sellers
Homeowners benefit from rent-to-own agreements in several ways.
- Larger buyer pool: If the seller is having trouble finding a buyer, a rent-to-own option may broaden their prospects by creating an opportunity for prospective buyers whose mortgage applications were denied.
- Higher sale price: Since the homeowner is offering the opportunity to purchase a home and build equity upfront, they may be able to request a higher sale
- Financial advantages: If the renter doesn’t purchase the home, the seller keeps the option fee and the monthly payments made throughout the rent-to-own agreement.
Cons For Home Sellers
There are disadvantages homeowners must consider with rent-to-own agreements.
- Purchase isn’t guaranteed: If the renter has a lease option agreement, they may not buy the home at the end of their lease. When that happens, the seller may need to restart the process of selling their home.
- No lump-sum payment: Many sellers use the money from selling their house as a down payment on a new home. With rent-to-own, sellers typically won’t get a lump-sum amount to use as a down payment.
- Housing market changes: Because the home sale price is locked in upfront, the seller may make less if the home’s value soars after the renter purchases the property.
How To Purchase A Rent-To-Buy Home In 7 Steps
There’s more to rent-to-own than paying rent until you purchase the home. Use the following steps to find the perfect rent-to-buy scenario for you.
1. Find A Rent-To-Own Home
A good place to start is rental listings. Filter the listings to display rent-to-own housing. If you’re already renting a home, see if a least-to-own agreement is something your landlord would be open to.
Because most rent-to-own properties are in slow markets for homeowners, your best bet will be to identify landlords who want to sell.
2. Negotiate A Rent-To-Own Agreement
You and the homeowner will sign a contract that sets the home’s final sale price or outlines that the renter will pay fair market value for the home when the lease ends.
The contract should also indicate:
- The length of the lease
- The monthly rental amount
- The portion of monthly rent that goes toward the home’s purchase price
- Who is responsible for routine home maintenance or any extensive repairs
Local laws may complicate this arrangement because some areas require landlords to perform specific duties regardless of a contract’s terms. Consult with a real estate attorney. Have them review the terms of the contract before you sign it.
3. Get A Home Inspection And Appraisal
Renting to own is as big a decision as buying a home. That’s why you should treat the rent-to-own agreement with the same caution as a traditional home purchase.
One way to protect your investment is to order an independent pre-purchase appraisal to establish the home’s fair market value and verify that the agreed purchase price is fair.
Keep in mind that the purchase price is permanent. You’ll pay that price even if the home is worth less by the end of your lease. Since a lender can’t lend more than the appraised value from the lender’s appraisal, you’ll have to find a way to pay the difference.
You should also schedule a home inspection before you sign the agreement to help make sure you aren’t agreeing to purchase a home with potential problems or needs significant repairs.
4. Do Your Due Diligence
To protect yourself from rent-to-own scams, ensure the home’s property taxes are up-to-date and there are no liens on the property. You’ll also need to check that the landlord is the rightful property owner and can legally rent the home. Review recent tax bills, conduct a house title search or look at recent mortgage statements.
Before you sign the agreement and pay rent and the option fee, have a real estate attorney review the agreement and explain your rights. Find out what happens if you miss any payments or make late payments.
5. Pay The Option Fee
After signing the contract, you’ll pay the one-time, nonrefundable option fee – also known as the option premium or option money. It gives you the first opportunity to purchase the house at the end of your lease.
The option fee prevents anyone else from purchasing the home while you’re leasing it. The fee amount can vary but usually ranges from 1% to 5% of the home’s final sale price and contributes to the down payment.
The option fee is applied to the down payment when you buy the home. With some lease purchase agreements, you may not need to pay an option fee because you agreed to purchase the house at the end of the lease. Check your agreement and make sure you understand your obligations before signing.
6. Make On-Time Monthly Payments
You must make your monthly payments on time. A late or missing payment may void your agreement, and you’ll risk losing the money you invested in the home.
Another reason to pay on time each month is that it will help you continue to build credit, which can help you secure a mortgage at the end of your lease.
7. Shop For A Mortgage
Once you’re nearing the end of your lease agreement, it’s time to shop for a mortgage. Not all mortgages or lenders are the same. Lenders will quote different interest rates and closing costs. By shopping around for a lender, you can save thousands of dollars.
Using online tools, like a mortgage calculator, plug in different interest rates and home prices to see how much your monthly mortgage payment would be. And look beyond loan terms. Select a lender that has your best interests in mind and can provide stellar customer service over the life of your home loan.
The Bottom Line
When you rent-to-own, take some time to ensure this is the right decision – and act as if you’re purchasing the home. Carefully weigh the pros and cons of the situation, do your research and have the home inspected and appraised.
You’ll also need to make sure you can qualify for a mortgage. If you’re ready to take the next step in the home buying process, you can start the mortgage approval process today.