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Rent-to-Own Homes, Explained
“If you’re renting, you’re just throwing your money away.” No doubt you’ve heard this oversimplification many places. Of course, a decision about whether to rent or buy a home is rarely that black and white: Either can make sense depending on your situation.
What if there was a way to combine the pros of both? Some say a rent-to-own deal is that happy medium. When you rent to own, part of your rent goes toward purchasing the home you’re renting at some later date. So instead of evaporating into thin air, your rent is actually laying a foundation for your future — literally.
Sounds great, but as with any major financial decision, there are pros and cons to rent-to-own deals. We’ll discuss the basics of rent to own, its benefits and drawbacks, and a few alternatives below so you can make an informed decision on whether it’s right for you.
Rent-to-Own 101: How Does It Work?
The process starts, of course, with a contract. Actually, in this case, it starts with two: a rental agreement and an option to purchase. Here’s what you need to know about both:
Your rental agreement will look much like a standard lease. It will specify your rent (more on this in a minute) and the term — in most cases, it will be two or three years.
There will be several standard terms and conditions you’ll need to meet: For instance, no smoking in the house, no pets, occupancy limits, and general conduct requirements. Violate these terms, and just like any tenant, you can be kicked out. However, this time, you also risk losing any money you’ve paid toward the home’s eventual purchase.
One big thing that may be different in this lease agreement: You, the tenant, may be responsible for maintenance costs and general upkeep of the home instead of the landlord. The logic here is that you’ll be motivated to keep the house in top shape if it will be yours in a few years. However, the landlord would still be on the hook for any repairs so major that the home would be uninhabitable without them.
The lease option gives you dibs to purchase the home you’re renting, typically valid for a term equal to the lease term set forth in your rental agreement. So if the rental agreement specified a three-year lease term, the lease option will usually give you three years to buy the house without worrying about anyone else swooping in and snatching it out from under you.
To maintain first dibs, you’ll pay an option fee. The amount can vary widely: According to Zillow, anywhere from 2% to 7.5% of the home’s purchase price is typical. This option fee is then credited toward the home’s purchase at the end of your term. However, if you decide not to buy, you’ll lose the money.
Make sure you’re signing a lease option, and not a lease purchase. Sometimes these terms are used interchangeably, but a lease option gives you just that — the option to buy the home. A lease purchase obligates you to buy the home and means the seller can take legal action if you try to back out.
How Much Does Rent-to-Own Cost Me?
First, let’s talk about rent. A certain percentage of your rent will usually go toward the purchase price of the home. This is something you can, and should, negotiate with your landlord. One thing to keep in mind when you negotiate: Because of this credit, you will likely be paying more to rent the home than you otherwise would. For instance, a house that would normally go for $1,000 a month might go for $1,250, with the extra $250 saved as credit toward the home’s purchase. So if you seek a higher credit, your rent may rise accordingly. Also note that your lease will probably specify that if you’re late paying rent, you’ll lose that month’s rent credit.
Next, let’s talk about the home’s purchase price. In most deals, you will agree to a purchase price upfront, typically current market value or a bit higher. In limited other instances, you may delay that decision until your lease term is up. Whether one or the other will be more beneficial hinges on whether the home’s value rises or falls during that time. A key point in either scenario, however, is that the purchase price is also negotiable — just like you’re buying a house the traditional way.
Let’s look at an example. You enter a two-year rent-to-own agreement for a townhome. The option fee is 3% of the home’s $200,000 purchase price, or $6,000. This is due up front. Your monthly rent is $1,600, and 20% ($320) goes toward the purchase of the home every month. (Your landlord will probably put it in an escrow account during your lease.)
At the end of your two-year lease term, assuming you exercise your option to purchase, the fixed $200,000 purchase price will be discounted by a) the amount of the option fee and b) the total rent credits. So subtracting the $6,000 option fee brings the price down to $194,000. Then, subtracting $7,680 in rent credits ($320 x 24 months) further reduces it to $186,320.
And remember: If you decide not to purchase the house, the option fee and credits are nonrefundable.
Who Benefits Most From Rent-to-Own Agreements? Who Should Pass?
For the right buyer and seller, a rent-to-own deal can be a win-win. But on both sides, as with any major financial decision, there are pros and cons you’ll want to note.
Pros for buyers
Rent-to-own can be worth looking into for would-be buyers who simply can’t wrangle a mortgage the traditional way. Typically, that’s because you either lack enough cash for a down payment or your credit score isn’t strong enough to be approved for a mortgage (or both). With a rent-to-own agreement, you get more time to boost your credit and save up, all while getting a head start on building some equity.
You may also benefit from a rent-to-own agreement if you are reasonably sure you want to stay in the house and neighborhood long-term, but still want to “try it out” while maintaining an escape route (albeit a pricey one). If you can lock in a purchase price before the home’s value rises, you may be able to save in the long run, too.
Pros for sellers
Of course, there are some benefits for the sellers, too: They get a long-term tenant who has a big stake in taking care of the property, and the nonrefundable option fee helps reduce some of their risk if the buyer eventually walks.
They can often still get a high sales price and rent for the home, even in a shaky market, because the tenant/buyer gets to start building equity from the get-go. They also won’t have to pay the pricey real estate commission (usually 3%-6% of the purchase price) they would if they sold their home the traditional way.
Cons for buyers
While a lease option gives you first dibs to purchase the home you’re renting, it doesn’t guarantee that you’ll be approved for a mortgage at that time. If you are unable to boost your credit or save enough for a down payment during your lease, you could still be shut out — and you’ll lose all the money you paid toward the purchase, too. To help protect against this scenario, experts recommend meeting with a mortgage lender before signing the deal to know exactly what you’ll need to qualify at the end of the lease.
When you lock in a purchase price up front, you also risk watching the home’s value drop during your lease. If that happens, you could be stuck paying an inflated price for the home simply so you don’t lose your option fee and rent credits. Be sure to research home prices and do a home inspection before signing — these things will help you be more confident that the home is actually worth the price.
You also want to be sure your landlord is on solid financial ground before closing a rent-to-own deal. If he or she falls behind on the mortgage or loses the house for some other reason while you’re renting, you probably also lose the option to buy and all of the money you’ve put toward the purchase price. To help protect yourself, do a title search before signing anything so that you can make sure the property is actually your landlord’s to sell.
Finally, you should be wary of a rent-to-own agreement if you’re not absolutely sure you can be a model tenant during your term. Paying your rent late means you’ll probably forfeit that month’s credit, and violating any of the lease terms could get you kicked out of the home — minus, of course, your option fee and any rent credits you’ve paid.
Cons for sellers
The biggest con of rent-to-own for a seller is that if a willing buyer showed up on your doorstep offering full price (or more) for your home, you would have to refuse — your tenant’s lease option gives them that right exclusively during the contract term. If you lock in a purchase price initially (the most likely scenario), you may leave money on the table over a traditional sale if your home’s value climbs dramatically.
Finally, though they have a strong financial incentive to buy, there’s always the chance that your tenant will walk away at the end of their lease, leaving you at square one with a house you either have to rent again or sell.
Alternatives to Rent-to-Own Deals
It’s wise to evaluate other options before committing to a rent-to-own deal. Here are a few alternatives to consider before signing on the dotted line:
An FHA-backed mortgage or USDA loan
You may lack the credit score and traditional 20% down payment for a traditional mortgage, but remember to investigate an FHA loan. If you’re a first-time buyer, you can put as little down as 3.5% if you have a credit score of at least 580 and meet other criteria, such as steady employment and a certain debt-to-income ratio. You will, however, have to pay mortgage insurance to help lessen your lender’s risk.
USDA loans offer similarly forgiving terms for first-time home buyers if you’re willing to live outside a major metro area.
In this scenario, the seller actually finances the home purchase for you instead of a mortgage lender. You can live in the home and make installment payments toward its purchase, and usually pay a much bigger “balloon payment” before completing the purchase.
This kind of deal can be speedy and tailored to the needs of both parties, but there are a lot of risks, including not being able to make the balloon payment because you still can’t obtain financing. To learn more about contract-to-deed purchases, read up in this article from the Federal Reserve Bank of Minneapolis.
Just continue to rent and save
This is your safest option, and likely the one most financial experts will recommend. If you’re truly committed to saving up and building your credit, there may be little reason to jump the gun with a rent-to-own deal. After all, if you can afford the option fee and higher rent that these deals require, then put all that money you saved in a high-yield savings account or money market account. Continue to add to it by finding a place with lower rent, and give yourself the freedom to obtain a mortgage the regular way in the future.
How Do I Find Rent-to-Own Homes?
Unfortunately, finding rent-to-own homes isn’t quite as simple as finding properties that are for sale or rent. Online, you can try websites such as HousingList, RealtyStore, or IRentToOwn, but you will have to pay a fee with these before you can view any significant information or contact sellers. Craigslist can be a good free option; searching “rent to own” in the housing section turned up about 50 listings near me.
You also have nothing to lose by zeroing in on a few for-sale homes in your preferred neighborhood, especially if they’ve been on the market for a while. Ask the sellers whether they’ve considered rent-to-own deals — they may be open to the option, especially if they’ve already moved and are paying a second mortgage for an empty home.
If you’re currently renting a home that you would like to buy, it also certainly doesn’t hurt to ask your landlord if they would consider a rent-to-own deal.
Fear of Commitment? Don’t Rent to Own
For tenants and would-be buyers, the key to successful rent-to-own deals is commitment. If you can commit to saving, cleaning up your credit, and buying the home you’re renting, you can benefit from the arrangement.
On the other hand, if you don’t think you’ll have enough time or discipline to be able to change your financial situation, or if you’re on the fence about the house you’re renting, you could lose a lot of money by walking away, whether because you wanted to or were forced to. You’ll be better off renting a smaller, cheaper place while scrimping and saving the old-fashioned way.