Rent-To-Own Homes: A Complete Guide
When buying a home, you’ll need a good credit score and typically a down payment to qualify for a mortgage. But what do you do if you don’t have good credit or are struggling with a lot of debt?
For those who are trying to decide between renting or buying a home, one option to consider is a rent-to-own home. But before you jump into a contract, it’s essential to understand the process, rewards and potential risks.
What Is A Rent-To-Own Home?
A rent-to-own home – also called a lease-to-own-home – is purchased through a rental agreement with a homeowner. A portion of your monthly rent payments will go toward reducing the sales price of the house during the time of your lease. After that time is up – usually 1 to 5 years – you’ll have the option to purchase the home.
These deals are more common in slow real estate markets where it’s difficult for homeowners to sell outright. They can be a viable option for renters looking to achieve homeownership.
However, lease-to-own agreements lose appeal in seller’s markets, when it’s easier to sell a home. With the potential of other offers, why take the risks associated with a rent-to-own agreement? The tenant may not qualify for a mortgage at the end of the lease period, or in a worst-case scenario, might trash the property and leave the owner with a mess.
To prevent riskier outcomes, some landlords will use a lease-purchase as part of the rent-to-own agreement. This legally obligates the renter to purchase the home at the end of the lease. Landlords who are okay with taking on such risks may keep the purchase of the home as an option instead of an obligation.
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How Does Rent-To-Own Work?
Rent-to-own agreements start when a buyer and a homeowner agree that the buyer can rent the property for a period of time. After that time, the buyer is required or has the option to buy the property, depending on the agreement type.
Buyers who enter into a rent-to-own agreement pay an extra premium – sometimes referred to as an option fee – on top of the rent. This premium goes toward the down payment on the purchase of the home. Usually, this payment is nonrefundable. This adds incentive for renters entering into this agreement to be sure they want to buy the property at the end of the agreement.
Lease-Option Vs. Lease-Purchase
There are two different types of leases in a rent-to-own agreement: lease options and lease-purchases. A lease-option gives you the choice to buy the home or choose not to at the end of the lease. Though purchasing the home is not a legal requirement, if you do decide to walk away, you’ll lose any money you paid toward the purchase price during your lease.
A lease-purchase means you’re legally obligated to buy the home by the end of the lease.
It’s important to understand the terms of your contract before signing it. So having a real estate attorney review the contract and answer any of your questions is a good idea. You’ll also want to speak to a mortgage lender to make sure you understand the requirements to qualify for a loan when it’s time to buy the home.
Rent-To-Own Pros And Cons For Potential Home Buyers
As with any big decision, it’s important to weigh the pros and cons. Depending on your situation and your financial goals, rent-to-own might be the right choice for you to purchase a home.
- More accessible: A rent-to-own agreement gives people who would otherwise struggle to qualify for a mortgage loan a path toward buying a home.
- Build credit: Potential home buyers have a chance to build their credit, boost their income or take other steps to make themselves more attractive to mortgage lenders during a set period of time.
- Financial growth: If you are able to improve your financial situation by the end of the rental period, you may be able to qualify for a mortgage or even a better interest rate.
- Fixed purchase price: You can lock in a purchase price at the beginning of the rental period, which can be especially beneficial if home prices are
- Build equity: If the option fee or a percentage of the rent payment is applied to the home’s purchase price, you can build equity in the home before you buy
- Familiarity: You can try out the home or neighborhood while accumulating the necessary funds for your down payment.
Renting-to-buy does come with its share of pitfalls. Plenty can go wrong with these transactions. It’s up to you to determine if the risks are worth the possible reward of becoming a homeowner.
- Sunk costs: If you decide not to buy the home, you’ll lose the upfront option fee with no home to show for it. Additionally, the rental money you paid each month won’t go towards equity or reducing the home’s purchase price.
- Mortgage application rejection: You may reach the end of the rental period without improving your financial situation, which could result in failing to qualify for a mortgage.
- Decline in market value: If the home loses value during the rental period you’ll still need to pay the seller the amount you agreed on. For example, if you agreed to pay $200,000, you’re obligated to pay that price even if the house loses value and is only worth $170,000.
- Late rent penalties: In some cases, if you’re late paying your rent, you could lose the right to purchase your home and you’ll lose all of the money you’ve already put into it. So make sure to read the fine print and have a real estate attorney take a look at the agreement before signing..
- Hidden problems: There could be problems with the home that you aren’t aware of until you’re ready to buy it. The seller may have issues with the title or may not own the property, or there may be major issues that a home appraiser won’t approve.
The best advice to avoid problems when entering a rent-to-own agreement is to treat the process like a home purchase. That means getting a home inspection, consulting a real estate attorney and doing a title search before signing an agreement.
Lease-To-Own Pros And Cons For Homeowners
There are many reasons homeowners may enter into a rent-to-own agreement. However, there are a few risks they take on as well.
- Larger buyer pool: If the seller is having trouble finding a buyer, a rent-to-own option could widen their options by creating an opportunity for people who may have had their mortgage application denied.
- Better tenants: A rent-to-buy tenant is a potential home buyer and is more likely to stay in the home for the long term and take better care of a home they hope to purchase.
- Higher sale price: Since the homeowner is offering a special opportunity to purchase the home, sellers may be able to ask for a higher sales price.
- Financial advantages: If the renter decides not to purchase the home, the seller keeps any extra money paid toward the purchase price.
- No guaranteed purchase: If the renter has a lease-option agreement, they can change their mind at the end of their lease and not purchase the home. Since there is no guarantee, the seller may have to restart the process.
- 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 don’t typically get a large lump sum to use on a down payment.
- Housing market changes: The seller may lose cash on the deal. If the purchase agreement locks in a sale price at the beginning of the lease and home values go up, they may end up selling the home for less than what it’s worth.
On the flip side, if the buyer agrees to pay the fair market value of the home at the end of the lease and home prices drop, the seller would have been better off selling the home or at least locking the price in at the time of the agreement. It’s a bit of a gamble for the seller.
How To Find Rent-To-Own Homes
If you’re interested in finding a rent-to-own or lease-to-own home, a good place to start is filtering rental listings to those with a rent-to-own option. If you’re renting somewhere you like, you could also see if it’s something your landlord would be open to.
Keep in mind, you may have to look in less-popular areas. Most rent-to-own properties are in markets where owners are having a hard time selling the property. Your best bet is to find a landlord who wants to sell.
How To Purchase A Rent-To-Buy Home In 5 Steps
There is more to rent-to-own than paying rent until you want to purchase the home. Assuming you’ve already found your propertyand done your due diligence researching the home, the first step is working with the seller to draft and sign a rent-to-own agreement.
1. Obtain And Review The Rent-To-Own Agreement
First, you and the homeowner sign a contract stating the final sales price of the home or the agreement to pay fair market value for the home when the lease ends.
The contract will also indicate how long you’ll rent before you have to decide whether to buy and the amount of rent you’ll pay. The contract should also state how much of your monthly rent will go toward reducing the sales price of the home and what happens to any extra rent money you pay each month. In most rent-to-own agreements, that extra money is nonrefundable.
An important consideration that many home buyers forget is home maintenance. Your agreement should state who is responsible for routine maintenance or any extensive repairs.
Local laws may complicate things because, in some areas, landlords are required to perform certain duties regardless of what your agreement states. You should hire a real estate attorney to review the terms of the contract before you sign it.
2. Get A Home Inspection And Appraisal
Deciding to rent-to-own is as big a decision as buying a home. In a lease-purchase agreement, you technically buy the homeimmediately. Even with a lease-option, you’re still financially committing to the purchase because some of your rent money will go toward purchasing the home and you’ll lose that money if you decide not to purchase. That’s why it’s important to 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 appraisal before deciding on a purchase price and signing a rent-to-own agreement.
The appraisal will give you the fair market value of the home so, if you’re locking in a purchase price at the time of the agreement, you’ll know you’re getting a fair price. Keep in mind that if you agree on a purchase price now, you’ll have to pay that price even if the home isn’t worth that amount at the end of your lease. Since a lender can’t lend more than the appraised value of a home, you’ll have to find a way to pay the difference.
You’ll also want to schedule a home inspection before you sign the agreement to make sure you aren’t agreeing to purchase a home that has potential problems or needs repairs.
To protect yourself from a few common rent-to-own scams, ensure that property taxes have been paid to date and there are no liens on the property. You’ll also need to check that the landlord actually owns the home and can legally rent to you before signing an agreement or paying any money.
You can do this by reviewing a recent tax bill, the title to the property or a recent mortgage statement. Before you sign the agreement and pay the option fee, have a real estate attorney review the agreement and explain your rights as a renter. Make sure you understand what happens if there are any missed or late payments.
3. Pay The Option Fee
After signing the contract, you’ll pay a one-time fee that gives you the first opportunity to purchase the house at the end of your lease. This nonrefundable fee may also be called the option premium or option money.
The option fee prevents anyone else from purchasing the home while you’re leasing it. These fees can vary, but they usually total around 1% – 5% of the home’s agreed-upon final sales price. It’s a bit like putting a down payment on a home.
If you decide to buy the home, the option fee is applied to the purchase price. In some lease-purchase agreements, you may not need to pay an option fee because you’re already agreeing to purchase the house with no option to back out. Check your agreement and make sure you understand your financial obligations before signing.
4. Make Your Monthly Payments On Time
When you’re in a rent-to-own agreement, it’s imperative you make your monthly payments on time. A late or missing payment could void your agreement and risk losing any money you already invested in the home. Even if a late payment doesn’t void your agreement, the additional money you pay toward the final purchase price of the home may not be added that month.
Another reason to pay each month and on time is that it will help you continue building credit, which can help you secure a mortgage at the end of your lease.
5. Shop For A Mortgage
When you’re nearing the end of your lease agreement and getting ready to purchase the home, you’ll want to shop for a mortgage just like a regular home buyer. Not all mortgages are the same and neither are all lenders. Different lenders will quote different interest rates and closing costs.
Using online tools, such as a mortgage calculator, can help you compare how much you can expect to pay per month. By shopping around, you could save thousands of dollars. You also want to make sure you choose a lender that has your best interest in mind and will provide stellar customer service over the length of your home loan.
The Bottom Line: Is Rent-To-Own A Good Idea For You?
When you rent-to-own, act as if you are purchasing the home. Take some time to make sure this is the right decision for you. If you can’t qualify for a mortgage now, make sure you’ll be able to by the end of your lease by working to improve your financial situation.
Carefully weigh the pros and cons of the situation to decide if rent-to-own is right for you. Make sure to do your research, have the home inspected and appraised. You’ll want to hire a real estate attorney who can advise you before signing any paperwork or making any payments.
Whether you’re ready to rent-to-own or deciding if it’s right for you, you’ll 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.