Owning a home may be a near-term goal of yours, but what if it's currently not within your reach? Maybe you're fairly young and you don't have enough money saved for a down payment to purchase a home. Maybe your credit score is in the dumps, and it needs to improve substantially so you can qualify for a mortgage. If you're not in a strong enough financial position to buy a home right now, but you've already settled on your target neighborhood, then it could make sense to enter into a rent-to-own contract rather than sign a traditional lease agreement.
Here, we'll discuss how the rent-to-own program works and the pros and cons involved.
How does renting to own work?
You're probably familiar with a standard rental agreement: You sign a lease for a preset period of time, during which you're required to make rent payments to your landlord. That money is your landlord's to keep in full, and the only thing you get in exchange is a roof over your head.
With a rent-to-own agreement, you sign a contract that gives you the right to buy the home you're renting after a specified period of time -- usually two to five years. As part of that contract, your landlord will agree to hold back a certain portion of your monthly rent payments that will go toward your home's purchase price, thereby making it easier for you to afford that home once your rental period is up, while also allowing you to effectively build equity in that home even while you're technically just a renter (though to be clear, you won't be able to borrow against that equity until you actually become the owner).
Of course, that's the simplified version. There are numerous specifics that come into play with rent-to-own homes that can vary from contract to contract.
What are the different types of rent-to-own agreements?
Rent-to-own homes usually come with one of two legal arrangements behind them:
- A lease agreement with the option to buy, which gives you the right to buy the home you've been renting but does not obligate you to do so.
- A lease-purchase agreement, which obligates you to buy the home you've been renting at the end of your contract.
Clearly, the former arrangement offers more flexibility than the latter. If your circumstances change, or you decide you no longer want to buy the home you've been renting, you're effectively off the hook. With the latter, you're locked into buying that home.
What rent-to-own contract terms should you be familiar with?
Once you determine what type of rent-to-own agreement you'll be entering into, you'll need to review the terms of your contract to understand what obligations you have under that lease. Specifically, you'll be looking out for language related to:
- Purchase price: How much will you be expected to pay for your home once you're ready to buy it? Will you pay a preset price that's stated up front? Or will the sale price be a function of that home's market value at the time of purchase? These details should be spelled out in your agreement.
- Monthly payment: What will your monthly payment be, and how much of it will go toward rent versus your eventual down payment?
- Maintenance, insurance, and taxes: Who will be responsible for maintenance on your home, property taxes, and homeowners insurance while you're renting it? In a standard lease agreement, those costs are the landlord's responsibility. In a rent-to-own arrangement, you may need to share in those costs if that's what your contract dictates.
- Option fee: This is a one-time, nonrefundable fee that gives you the right to purchase your home at the end of your lease agreement. This fee is typically equal to at least 1% of the home's purchase price or current market value, but it can be higher.
- Length of lease: How long will you rent the home before buying it?
- Mortgage application: If you're buying your home at the end of your lease, you'll need to apply for a mortgage, just as you would if you were buying a home the traditional way. But what happens if you don't qualify for a mortgage? And how much time will you be given to get approved? These terms should be spelled out clearly.
Generally speaking, there are no preset rules when it comes to rent-to-own agreements, and one contract can differ drastically from another. Also, as is the case with most lease agreements, the terms of your rent-to-own agreement are negotiable, so if there's something in your contract you don't like, you can always speak up about it -- or walk away if the terms don't work for you.
Benefits of rent-to-own agreements for tenants/buyers
As a potential buyer, there are plenty of good reasons to enter into a rent-to-own contract. For one thing, if you've found a home you really like in your target neighborhood, but you need time to build your credit and improve your finances, then a rent-to-own setup spares you from losing that property to another buyer who can afford to purchase it right away.
Furthermore, when you rent to own, you're effectively forced to save money toward your home's down payment. If you're not great at budgeting or saving money in general, it's a good way to stay on track. And remember, some of the money you pay your landlord each month goes toward your down payment, so you're not throwing that entire sum away for no long-term benefit, as would be the case with a traditional lease agreement.
Additionally, if you enter into a rent-to-own agreement with the option to back out and not go through with the purchase, you'll have an opportunity to see whether the home in question is really right for you. Sometimes, problems with homes don't reveal themselves during an initial inspection; they only become obvious once you've been living in that home for a while. With a rent-to-own agreement, you minimize the risk of unknown repairs that traditional homebuyers face.
The same holds true for vetting your neighborhood -- you might think you've found the right area to settle down in, but if, after a year or two of living there, you change your mind, you may be able to back out of buying your home if your rent-to-own contract allows for that. When you buy immediately, you're more likely to feel stuck.
Drawbacks of rent-to-own agreements for tenants/buyers
Rent-to-own agreements have their disadvantages, too. For one thing, you'll generally have a much higher monthly payment for a rent-to-own property than you would for just renting a comparable home in the same neighborhood. The reason is that you're paying extra so that some of your money is going toward your home's down payment. And while the forced savings may be nice, if you have the discipline, you could also just as easily rent a cheaper home to begin with and save that money yourself.
Additionally, the option fee you pay upfront is nonrefundable, which means that if you eventually decide not to go through with your home's purchase, you lose that money. The same could hold true if you apply for a mortgage once your rental period is up but aren't approved. Furthermore, if you sign a lease-purchase agreement, you're effectively obligated to buy the home in question even if you change your mind, and breaking that contract could result in severe financial penalties.
Another thing: When you sign a standard rental agreement, it's your landlord who's responsible for things like maintenance and property taxes. In fact, one big benefit of renting, in general, is not having to deal with those facets of homeownership, since you're not the owner.
But in a rent-to-own arrangement, depending on the terms of your contract, you may take on that responsibility well before you're the official homeowner. And during that time, you get none of the tax breaks homeowners are entitled to.
Finally, the terms of your contract could result in you getting a very bad deal on your home. Imagine you lock in your home's purchase price based on its value the day you sign your lease, with the intent to buy that home three years later.
Well, what if market conditions change, and your home is worth a lot less in three years' time? Suddenly, you're locked into a higher purchase price. Not only does that mean you're stuck overpaying, but it puts you at risk of not getting a mortgage if your home doesn't appraise for a high enough price to satisfy potential lenders.
Tenant/buyer benefits and drawbacks of rent-to-own agreements
• Possibly avoiding missing out on a property you'd like to buy but can't right now.
• Part of your rent goes toward your down payment, providing a long-term benefit you don't get with standard rent and forcing you to save.
• With the option to buy, you get to determine whether a certain home and area are right for you before committing long term.
• Likely to have a much higher monthly payment. Losing your option fee if you don't end up buying.
• Facing steep penalties if you choose not to buy after entering into a lease-purchase agreement rather than having the option to buy.
• Possibly being responsible for maintenance and property taxes before becoming eligible for tax breaks as the owner.
• Facing the risk that the home could be worth much less by the time you’re ready to buy.
Benefits of rent-to-own agreements for sellers
A rent-to-own agreement can work out quite well from a seller's perspective. If you're looking to sell your home and are having difficulty doing so, a rent-to-own agreement could be your ticket to finding a buyer. Meanwhile, you get to collect rent, which serves as income for you, all the while being fairly assured that your tenant will treat your property with respect since there's a good chance he or she will own it eventually.
Even if your tenant doesn't end up exercising the right to buy your home, remember that it's common practice for rent-to-own tenants to share in maintenance and property tax costs during their rental period. As such, even if you wind up having to search for a buyer all over again, you'll have benefitted from higher rent and fewer ownership costs.
Finally, if your tenant doesn't end up buying your home, the option fee that was paid up front is generally yours to keep. That gives you a little extra cash to improve or market your home to attract another buyer.
Drawbacks of rent-to-own agreements for sellers
There's risk associated with renting to own from a seller's perspective, too. For one thing, if you enter into a contract where your tenant has the right to buy or back out once the lease is up, you could get stuck having to repeat the process of finding a buyer if your tenant doesn't purchase your home. But by waiting out your lease period, you risk having to sell your home at a lower price than it could've commanded earlier.
Imagine you enter into a rent-to-own agreement at a time when your home's market value is $200,000. What happens if three years later, when your tenant's lease wraps up, your home is only worth $160,000 and your tenant doesn't move forward with buying it? Suddenly, you're stuck either holding onto that property for longer or accepting an offer that's much lower than what you could've gotten years ago.
Additionally, though tenants typically share in some of the maintenance costs in a rent-to-own agreement, you'll be responsible for the landlord's share. And if your goal in selling your home is to unload those expenses, a rent-to-own arrangement won't help you achieve that -- at least not for a number of years.
Finally, if you’re entering into a rent-to-own agreement because that's the best way to sell your home, that means you'll need to play landlord for a few years. That could include dealing with tenant complaints, managing rent payments, paying taxes on rental income, and dealing with a host of hassles you may not be interested in.
Seller benefits and drawbacks of rent-to-own agreements
• Likelihood of higher-quality tenants than in a traditional rental.
• May help in finding a buyer if you're having trouble selling.
• May get to share maintenance and tax responsibilities with the tenant, depending on the contract, unlike in a traditional rental.
• Will have benefited from higher-than-average rent even if the tenant doesn't buy.
• Keeping the option fee if the tenant doesn't buy, possibly using it toward home improvement and marketing.
• Possibly having to re-list the home for less if the tenant doesn't buy and the value drops.
• Still having to at least share in the expense of maintenance and taxes during the lease period, unlike in a traditional sale.
• Having to play landlord for a few years before you can officially unload your home.
How to find rent-to-own homes
If you're specifically looking to buy a rent-to-own property, it helps to find a trusted real estate agent and make that clear. An agent who knows the area may be aware of such properties on the market.
Another tactic you may need to employ is to find a seller whose home has been on the market for quite some time without movement and suggest such an arrangement yourself. A seller who seems set on a specific purchase price but hasn't had any buyers may be willing to work with you if it means locking in an eventual sale at the right price point.
The bottom line on renting to own
There are pros and cons of renting to own from both a buyer and seller perspective. Before you decide to move forward, consider your alternatives. As a buyer, that could mean renting someplace cheap while you work to save money and boost your credit.
As a seller, that could mean accepting a lower purchase price on your home for a buyer who can complete that sale right away, or finding a tenant and signing a traditional lease agreement. Or, it could mean sinking some money into renovations.
Whether you're looking to buy a home or sell one, it could very well be that a rent-to-own arrangement is the right move for you -- but it pays to put a lot of thought into it before signing a contract.
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