Rent-To-Own Homes: How Do They Work and Are They Worth It?
Molly Grace9-Minute Read
July 24, 2020
Buying a home is a big deal. It requires a lot of planning, a lot of saving and a solid financial profile (including a good credit score and manageable debt).
For those who want to buy a home but don’t quite have their finances squared away, a rent-to-own home can be a way to – literally – get your foot in the door of homeownership.
Wondering if rent-to-own suits your needs? Let’s take a look at these agreements, including how they work and some of the pitfalls to watch out for.
What Are Rent-To-Own Homes?
If your finances aren’t ready for you to buy a home through the traditional route, a rent-to-own contract is an alternative worth considering.
With a rent-to-own agreement, you sign a lease just as you would if you were entering a regular rental agreement. However, your contract will also state that you have the option to buy the home at the end of the leasing period – in some cases, it may even state that you are obligated to purchase once your lease is up.
The contract may also state the purchase price of the home.
Rent-to-own homes are sometimes seen as beneficial for those who still need time to get their finances in order to be able to buy a home. This can be especially true if they’ve already found a home they really like and don’t want to have to wait to get their credit in shape to move in.
For example, imagine you find a home for sale that has everything you’re looking for – it has a lot of space, a great backyard and is close enough to your office to make your commute a breeze. You know you’d be happy in this home for many years to come, and you know you want to become a homeowner soon, once you’ve improved your credit and saved for a down payment.
Instead of having to watch sadly from the sidelines as your dream home is sold to another buyer, a rent-to-own agreement can help you get into the home you want now while also giving you time to prepare your finances for getting a mortgage.
Sounds great, right? While there can be benefits to getting into a rent-to-own agreement, it’s not a perfect solution, and there are some serious risks you’ll need to consider first before signing one of these contracts.
Let’s get into the nitty-gritty of how these agreements work.
How Does Rent-To-Own Work?
The thing to remember when considering a rent-to-own home is that there’s no one-size-fits-all contract, so the details of rent-to-own agreements can vary. This is why it’s so important to have a real estate attorney look over any rent-to-own agreement you’re considering signing.
What does the process usually look like? Typically, when you pay your rent each month as part of a rent-to-own agreement, part of your rent will be put toward your eventual home purchase.
For hopeful home buyers who’ve had trouble saving up for a down payment, this can be a good way to force yourself to save since it’s a part of the rent you pay each month. However, because part of the payment is going toward your equity in the home, you’ll likely pay more than what the average market rate is for rentals similar to yours.
So, if the rent normally would be $1,000 a month, you may pay $1,300 a month. Your landlord would then put aside that $300 to be credited toward your eventual home purchase.
The costs don’t end there. You may also have to pay a fee, called an option fee, to secure yourself the right to buy the home. This fee may be a percentage of the agreed-upon purchase price.
All of these costs are in addition to any fees you’ll pay as a renter, such as a security deposit. While rent-to-own homes are often viewed as a way of circumventing the high initial costs of homeownership, they often come with some hefty costs of their own.
At the end of the lease period, if you choose to buy, you’ll apply for a mortgage to purchase the home, and the amount you’ve paid your landlord toward the price of the home will be credited toward your purchase.
If you’re leasing a rent-to-own home, be prepared to have more responsibilities than a typical renter might.
Often, because you’re planning to own the home and thus have a vested interest in its upkeep, maintenance and repairs that are traditionally the responsibility of the landlord may fall to the tenant/buyer.
Take a look at your lease agreement to see who’s responsible for what, and make sure you’re prepared to cover the cost of any repairs or upkeep that may come up during your leasing period.
The landlord/seller is responsible for setting aside all money from the tenant that’s to be put towards the cost of the home, usually into an escrow account.
Additionally, these sellers should keep in mind that when they enter one of these contracts, they’re obligated to sell the home to the tenant once the leasing period is up. While a tenant may have the option to walk away from the property if they choose not to buy, if they do want to purchase the home, the seller must honor that.
Like we said, this all is typically how this process works. However, both parties should read everything very carefully and consult a lawyer before signing a rent-to-own contract. This will help you avoid unwanted surprises, like finding out that only some of the extra money you’re paying in rent is going toward your eventual purchase.
Types Of Rent-To-Own Contracts
As a tenant, when you enter into a rent-to-own agreement, there are two different ways your eventual home purchase can be written into the contract. With one, you’ll have the option to purchase the home once your lease is up. With the other, you’ll be obligated to.
Lease Option Agreement
With a lease option agreement, you’ll have the choice to purchase the home at the end of your lease. If you choose not to, you can simply walk away without penalty.
However, keep in mind that even though you’re allowed to walk away, when you participate in a rent-to-own contract you’re investing money in the home you one day plan to buy. When you walk away, you forfeit the money you paid your landlord to set aside for your purchase, as this money is typically nonrefundable.
Lease Purchase Agreement
With a lease purchase agreement, you’re agreeing to purchase the property at the end of your lease. Once you sign, you’re contractually obligated to go through with the purchase.
When dealing with this type of contract, it’s generally a good idea to involve some of the same professionals you might use if you were doing a traditional purchase, such as an appraiser, a home inspector or a title company. That way, you’re less likely to end up stuck buying a home that has a bunch of issues.
In fact, even if you’re signing a lease option agreement, getting the home appraised and inspected can help ensure that you aren’t agreeing to buy a home for more than it’s worth or investing your money in a home that needs more TLC than you can afford.
If a seller is keen on selling the property, they may prefer a lease purchase agreement or even insist on it. Be sure to think carefully before signing this type of contract, as you’ll likely face consequences if you decide you want to back out later on.
Pros And Cons For The Buyer
Let’s take a look at when renting-to-own can be a good idea for a buyer, and why it isn’t always what it’s cracked up to be.
For some, renting-to-own can be the best of both worlds; you get to set yourself up for homeownership by moving into the house you like now while also giving yourself the time you need to work on your credit and finances so that when the time comes you’re able to secure a mortgage loan to purchase the home.
Plus, it gives would-be buyers a way to take the home and the neighborhood for a test drive of sorts, with the ability to walk away from the purchase if they decide it’s not working for them (as long as their contract permits it).
Renting-to-own can potentially make homeownership more attainable for those who aren’t able to afford the large upfront costs that come with the traditional home buying process. Instead of having to come up with a 20% down payment just to get into a home, renters-to-owners can slowly build equity in the home through their monthly rent payments, which can lower the amount of cash they’ll need when the time comes to purchase.
Often, these agreements will also stipulate the purchase price ahead of time. If home values are rising, this can benefit the buyer since the price is already locked in.
On the other hand, there are also many ways in which renting-to-own can be the worst of both worlds.
As a rent-to-own tenant, you’ll likely be responsible for repairs and maintenance on the property. Having to pay for your own repairs is often one of the big downsides associated with homeownership, but with this homeowners get the benefit of having a valuable asset in their financial portfolio. Rent-to-own tenants have to pay for repairs on a property that they don’t own yet – and may never own. If something goes wrong or you back out, all that money you’ve sunk into the home is gone.
Speaking of losing money, you’ll also lose out on your option fee and any rent that was set aside for the purchase if you walk away.
Additionally, it’s important to consider how much equity you’ll be able to build in the home before you’re expected to purchase it.
Let’s go back to our earlier example – your landlord is setting aside $300 from your rent each month to go toward your home purchase. In a year, you’ll have $3,600. If your lease period is only for 2 years, you’ll have $7,200 to put towards the purchase of your home. If the home costs $200,000, you’ll still need to bring more cash to the table if you want to put down 20%.
You may be able to qualify for a mortgage with a low down payment (some programs allow you to go as low as 3%), but it’s important to think ahead of time about what your options are and whether you’ll need to save in addition to what you’re paying in rent.
Unfortunately, there are also factors that you can’t control. You don’t have an ownership stake in the property until you close on it, so if, for example, the home is foreclosed on, you’ll lose the home.
In considering these cons, think about whether or not it might make more sense to go with a traditional rent agreement at the current market rate and put the extra money you would’ve spent on a rent-to-own property in a savings account for a down payment on a home. That way, you don’t risk losing that money should you decide to back out of the purchase and you don’t have to worry about budgeting for repairs or maintenance on your rental.
Pros And Cons For The Seller
What does a landlord/seller stand to gain or lose from a rent-to-own agreement? Let’s take a look.
For sellers who are having trouble getting buyers interested in their home, offering the home as part of a rent-to-own agreement can widen the pool of potential buyers.
When you take on a rent-to-own tenant, you’ll have a steady stream of rental income for the duration of the lease and – if they signed a lease purchase agreement – a sure-fire buyer when the lease is up.
If your tenant signed a lease option agreement, the extra funds they’re paying to one day purchase the home act as insurance for you. If they decide to walk away, they forfeit that money to you.
Additionally, rent-to-own tenants are generally more likely to take good care of the property, because one day, if everything goes according to plan, it’ll belong to them.
In general, sellers don’t take on as much risk as buyers do in a rent-to-own situation, but there are still some pitfalls to be aware of.
If your main goal is to sell the house, renting-to-own can be a drawn-out and uncertain way to go about it. If your buyer signs a lease option agreement and decides not to buy at end of the lease, you’ll be left to find another buyer.
Even if the contract stipulates that the tenant must purchase the property, it’ll be a while before you’ll actually have sold the house. Plus, there’s always a chance that they won’t be able go through with the purchase when the time comes, especially if they haven’t been able to improve their finances enough to qualify for a mortgage. While you may have recourse if they break the contract, this can be a headache-inducing process, and you may not find it to be worth it.
You also should consider the risk that you’ll lose money on the home if values increase significantly between the time you agree on the purchase price and when you actually sell the home.
How To Find Rent-To-Own Homes
Not sure where to find rent-to-own homes for sale? This is another potential downside of deciding to rent-to-own: These homes can be hard to find.
You can start your search online by looking for rent-to-own homes in your area.
If you’re having trouble finding homes that are explicitly rent-to-own, you may want to start scanning home listings for properties that have been on the market for a while or that are being sold by individual landlords. Pay special attention to for sale by owner listings as you may have more luck with an individual seller than someone who’s selling through a real estate agent.
The Bottom Line
Rent-to-own homes can provide a more accessible entry into homeownership for some buyers, but these agreements don’t come without risk, and it’s important to thoroughly consider all of the pros and cons before you sign a rent-to-own contract.
To learn more about the journey to homeownership, check out more of our home buying articles on the Rocket HomesSM blog.
Get the right home loan for you.
Rent-To-Own Homes: What They Are, How They Work And If They’re Right For You
Thinking about renting-to-own? Learn more about what it is, how it works and the pros and cons of the rent-to-own agreement.