Rent-To-Own Homes: What They Are, How They Work And If They’re Right For You
Lauren NowackiOctober 03, 2019
You’ve heard it before: Buying a home is a big commitment, one that requires both financial and emotional readiness. To be financially prepared to purchase a home, you’ll want to have enough money saved for a down payment and be able to afford mortgage payments and the costs of homeownership. If you need to finance your purchase, you’ll also need a decent credit score and debt-to-income ratio to qualify for a mortgage. You’ll also need to commit to living in the same home for at least a few years and be responsible enough to make payments on time and maintain the home.
Typically, people may wait to start their home search until they are ready to buy a home. But if you’re looking to dip your toes into the market slowly while you get your finances in order or you’ve found your dream home and don’t want to let it go, you may have another option: rent-to-own.
What Does Rent-To-Own Mean?
Rent-to-own is an agreement to lease something with the option or requirement to purchase it after a given amount of time. When it comes to a home, a person will rent the house for a certain amount of time (typically 1-5 years) and then purchase the home by the time the lease ends.
How Does Rent-To-Own Work?
Renting-to-own involves more than paying rent and eventually buying the home. The first step is determining and agreeing on the sales price of the home or agreeing to pay the fair market value at the time of the sale. If the purchase price is determined before the agreement is signed, that price is locked in. After pricing is determined, the buyer and seller will draft and sign a rent-to-own agreement.
The rent-to-own agreement is the contract between the seller and the buyer. It spells out the terms of the agreement and should include the following:
· The sales price of the home or agreement to pay fair market value at the time of purchase
· Lease term (how long you’ll rent)
· The amount you’ll pay each month
· How monthly payments are applied
· Who is responsible for maintenance and repairs
· Typical rental terms and conditions
· Option to purchase, plus the option fee
Lease-Option Vs. Lease-Purchase
There are two different types of leases in a rent-to-own agreement: lease-option and lease-purchase. A lease-option gives you the choice to buy the home or not by the end of the lease. You’re not legally required to purchase the home; however, if you choose not to purchase the home, you’ll forfeit any money you paid toward the purchase during your lease.
A lease-purchase means you’re legally obligated to buy the home by the end of the lease.
Before signing the rent-to-own agreement or lease, have a real estate attorney review the contract. You’ll also want to speak to a lender to make sure you understand what you’ll need in order to qualify for a loan when it’s time to purchase the home.
To go along with the signed agreement, the renter pays a one-time, non-refundable fee that gives them the right to buy the house by the time the lease ends. This is known as the option fee, option premium or option money. It ensures you have “first dibs” on the home. No one else can purchase the property during the lease term. If you decide to buy the home, the option fee is applied to the purchase price. If you decide not to purchase the home, you will not get that money back. The amount you pay varies and is negotiable but is typically about 5% of the sales price.
In a rent-to-own arrangement, your monthly payment is above the fair market rent value to take into account both the cost to rent the property and the cost to help pay down the purchase price. Here’s is an example of how that works:
The buyer and seller agree to a purchase price of $250,000 with a lease term of 3 years. The seller agrees to pay 25% of the $1,500 monthly rent towards the purchase price. Each month, $375 is applied to the purchase price, lowering the price of the home for the buyer. At the end of 3 years, or 36 months, $13,500 is paid toward the purchase price of the home. When it is time for the buyer to purchase the home, the price is now $236,500.
Purchasing The Home
The process of purchasing a rent-to-own home is the same as purchasing a traditional home. In most cases, you’ll need a mortgage to finance the purchase. Depending on the loan option you choose, there are a few factors that will determine whether you get approved. These factors may include your credit score and debt-to-income ratio. Since the amount of money the lender can provide depends on the fair market value of the home, you’ll also need to get the home appraised. The lender can’t lend more than the appraised value.
If you agreed to pay the fair market value of the home at the time of purchase, you will most likely pay the appraisal amount, minus any money you contributed toward the purchase price during your lease term.
If the home appraises for less than the agreed-upon price, you may have a few options, depending on the type of lease you signed and the stipulations outlined in the rent-to-own agreement. You can renegotiate with the seller if the contract allows or you could pay the difference. If you signed a lease-option, you could also decide not to purchase the home and forfeit the money you’ve already paid into the purchase price.
If the home appraises for higher than the agreed-upon price, you get a deal on the home and have that much more equity.
Tax Implications for Rent-To-Own Homes
Until you purchase the home, you are a renter and the seller is the landlord and legal owner of the home. As such, the seller is still responsible for paying property taxes and you are not able to deduct mortgage interest or claim any other tax breaks for homeowners.
Pros and Cons of Rent-To-Own Homes
As with any big decision, it’s important to weigh the pros and cons of renting-to-own. Depending on your situation and your financial goals, it may benefit you to use this strategy to purchase your home.
Some benefits of renting-to-own include:
· You’ll get first dibs on the home you wish to purchase.
· You can “test drive” the home and neighborhood before fully committing to live there.
· Since part of your rent is applied to the sale of the home, you aren’t just throwing money away on rent each month.
· Since you are paying down the sales price, you are building equity in the home while you rent it.
· If you lock the sales price in at the beginning of your lease term and the market rises, you could get a great deal on the home.
· You have more time to save for a down payment and closing costs, increase your credit score and pay off debt. This can help you qualify for a mortgage – possibly at a better rate – and put you in a better financial position for home buying and homeownership.
While there are several benefits for renting-to-own, there are pitfalls that come with the arrangement, too. And if you aren’t a diligent renter or didn’t review the terms of your agreement before signing, you could wind up losing the home and thousands of dollars.
Beware of these drawbacks when renting-to-own:
· A late or missed payment could void your agreement and you could forfeit all the money you’ve already invested. The seller could also sell the home to someone else and kick you out.
· If the home appraises for less than what you agreed to pay, you may not be able to secure a mortgage or you may have to pay the difference. At that point, you’re paying more for the home than it’s worth.
· If you agreed to pay the appraised value of the home at the time of purchase and it ends up being more than you anticipated, you may not be able to afford the home.
· If you can’t secure a mortgage, you may have to forfeit the home and you won’t get back the money you’ve been paying. This could be a loss of thousands of dollars.
· If you signed a lease-purchase, you’re legally required to buy the home after the lease ends whether you can secure financing or not. If you can’t purchase the home, the seller may take you to court.
Avoiding Rent-To-Own Scams
If you are interested in these types of properties, be cautious of a few common rent-to-own scams and know how to avoid falling for them. Always ask for documentation proving the seller owns the house, so you aren’t paying upfront fees to someone who can’t actually rent to you. Such documents include a recent tax bill, mortgage statement, purchase documents or property title. Work with a real estate attorney to review your agreement before you sign it. They can help you understand your rights and any penalties laid out in the contract for late or missed payments. Schedule a home inspection before you sign the agreement so you don’t get stuck having to purchase a home that may need a ton of repairs.
Finding Rent-To-Own Properties
You can find rent-to-own properties on many online listing sites, but these listings are typically sparse depending on where you’re looking. Another option is to look for homes that have been on the market for a long time. Many sellers will offer rent-to-own if they are having trouble selling. If you are renting a home you love or if landlord has decided to sell, talk to your landlord about considering a rent-to-own option.
Deciding To Rent-To-Own
Deciding to rent-to-own may not feel like it’s as big of a decision as purchasing a home, but it is. If you sign a lease-purchase, you are technically buying the home since you will be required to purchase it at the end of your lease. If you sign a lease-option, you may not be required to purchase the home, but you are still committing to a big purchase. That’s because you are agreeing to pay thousands of dollars towards the future purchase – money you’ll lose if you don’t buy the home.
Make sure you put the same amount of work, education and care into your decision to rent-to-own as you would purchasing a home outright. Before you sign the agreement:
· Decide if you will be able to qualify for a mortgage at the end of your lease. If you are not willing or able to put in the work to raise your credit score, pay off debt, save for a down payment or correct any other issue preventing you from getting a mortgage, do not rent-to-own.
· Ask yourself if this is really the house you want to purchase. Does it have everything you want and need? Are there any deal-breakers or do you feel like you are compromising?
· Consider your future. Do you plan on getting married, having children, changing jobs or moving? Will the house be able to meet the demands of your future lifestyle?
· Review your budget. Will you be able to pay a higher rent that may come with a rent-to-own property? Will you be able to make payments on time?
· Get an inspection. Before you sign the agreement, make sure the house is in good condition.
· Speak to a financial advisor who can make recommendations based on your specific situation.
· Have a real estate attorney review your rent-to-own agreement.
Whether you decided to give rent-to-own a try or you’re still in the consideration stages, contact one of our Home Loan Experts to learn more about your eligibility. You may not even know that you could get pre-approved for a loan today. And if you don’t yet qualify, a Home Loan Expert can tell you what you may need to do so in the near future.
If you’re ready to purchase your home, call (800) 785-4788 or get started online with Rocket Mortgage® by Quicken Loans.