Rent-to-Own Homes: How the Process Works
In a traditional home purchase, an offer is accepted, the buyer and seller meet to exchange funds and settle final costs, and, at the close of the transaction, the property and its title change hands. Typically, buyers use a mortgage to finance the bulk of the purchase.
But sometimes there is an alternative way to buy a home: a rent-to-own agreement, also called a lease option or a lease-to-own agreement. When buyers sign this kind of contract, they agree to rent the home for a set amount of time before exercising an option to purchase the property when or before the lease expires.
It’s not a common way to purchase a property, and the selection of rent-to-own properties is tiny compared to the selection of properties available purely for lease or sale. In addition, rent-to-own contracts tend to favor the owner/landlord and can put renters at a disadvantage.
How Rent to Own Works
In a rent-to-own agreement, potential buyers get to move into a house right away. While many states have their own regulations, and no two rent-to-own contracts are alike, someone in a rent-to-own agreement typically rents the property for a set amount of time (usually one to three years), after which he or she can purchase the house from the seller. It’s not as simple as paying rent for three years and then buying the house, though. Certain terms and conditions must be met, in accordance with the contract.
Option Money: In a rent-to-own agreement, the potential buyer pays the seller a one-time, usually non-refundable lease option fee called option money or option consideration. As with stock options, this gives him or her the opportunity to purchase the house in the future. It is important to note that some contracts (lease-option contracts) give the potential buyer the right but not the obligation to purchase when the lease expires. If he or she decides not to purchase the property at the end of the lease, the option simply expires. If the wording is "lease-purchase," without the word "option," the buyer could be legally obligated to purchase the property at the end of the lease. Clarifying the wording is one of many reasons buyers should have the contract vetted by a real estate attorney before agreeing to it.
The size of the option is negotiable. There's no standard rate. It typically ranges between 2.5% and 7% (3% is common) of the purchase price. In some (but not all) contracts, all or some of the option money may be applied to the purchase price at closing. That's a valuable clause. Consider that if a home has a purchase price of $200,000 and a 7% option consideration, the buyer would need to pay $14,000 up front. That's a lot less than the $40,000 (the size of the standard 20% down payment) you'd make if purchasing outright.
Purchase price: The contact will specify when and how the purchase price of the home will be determined. In some cases, the buyer and seller agree on a purchase price when the contract is signed – often at or higher than the current market value. In other situations, the buyer and seller agree to determine the price when the lease expires, based on market value at that future point in time. Many buyers prefer to “lock in” the purchase price if possible, especially in markets where home prices may be increasing.
Rent: During the term of the lease, the potential buyer pays the seller a specified amount of rent, usually each month. In many contracts, a percentage of each monthly rent payment, called a rent credit, is applied to the purchase price. For example, assume the contract states that the buyer will pay $1,200 each month for rent, and that 25% of that will be credited to the purchase. If the lease term is three years, the buyer will earn a $10,800 rent credit to apply toward the purchase ($1,200 x 0.25 = $300; $300 x 36 months = $10,800). Factoring in these credits often makes the monthly payments slightly higher than the “going rate” for regular rentals. For the buyer, they act as down payments on the property. For the seller, they act as compensation for having taken the property off the market.
Maintenance: Depending on the terms of the contract, the potential buyer may be responsible for maintaining the property and paying for any repairs, homeowners association fees, property taxes and insurance. Because the seller is ultimately responsible for association fees, taxes and insurance (it’s still his or her house, after all), the seller may choose to cover these costs. Even in that case, the buyer still needs a renter's insurance policy to cover losses to personal property and provide liability coverage if someone is injured while in the home or if the buyer accidentally injures someone.
Be sure that maintenance and repair requirements are specified in the contract. Maintaining the property – e-g., mowing the lawn, raking the leaves and cleaning out the gutters – is very different from replacing a damaged roof.
Purchasing the property: If the potential buyer decides not to purchase the property (or is unable to secure financing) at the end of the lease term, the option expires. The buyer forfeits any funds paid until that point, including the option money and any rent credit earned. If the buyer cannot purchase the property but has a legal obligation to (as stated in the contract), legal proceedings may be initiated.
If the buyer wants to purchase the property, he or she typically applies for financing (i.e., a mortgage) and pays the seller in full. According to the terms of the contract, a certain percentage of the option money and rent paid may be deducted from the purchase price. The transaction is completed at the closing, and the buyer becomes a homeowner.
When Are Rent to Own Homes a Good Idea?
A rent-to-own agreement can be an excellent option for people who want a home but who don’t yet qualify for a mortgage or who aren’t quite ready for the commitment of ownership.
For example, you might have a bad credit score – one that’s below 620, the bare minimum some lenders will accept – but the circumstances that depleted that score are behind you and you’ve been steadily improving it ever since. Maybe your debt-to-income ratio is too high, but not by much, and you have enough room in your budget to make extra payments and reduce your debt significantly over the next couple of years. You might have a good job, or gotten one with a significantly better salary, but you haven’t been there long enough for a lender to consider it a stable source of income to repay your mortgage over the long run. Similarly, you might be successfully self-employed, but not have a long enough track record to make lenders comfortable. You might have started saving, but you haven't accumulated enough to meet the usual 20% down payment on a home.
If any of these describe your situation, renting to own might be a good idea. You can lock down a property you like now and possibly save yourself a move or two. Then you’ll have some time, typically in two to three years, to improve your credit score, lengthen your employment history, increase your savings or do anything else you need to make yourself a stronger mortgage applicant. And, if the option money or a percentage of the rent goes toward the purchase price, you also get to start building some equity.
To make rent to own work, potential buyers need to be confident that they’ll be ready to make the purchase when the lease term expires. Be wary of getting into this if there’s a more than 50% chance you’re going to move and not buy. Otherwise, you will have paid the option money – which could be substantial – and also have wasted money on the nonrefundable rent credits with nothing to show for it at the end. It isn’t likely that you’ll get a landlord/owner to agree to a refundable rent credit and refundable option fee to give you the flexibility to move.
If there’s a good chance would-be buyers still won’t be able to qualify for a mortgage or secure other financing by the time the lease expires, they should instead continue renting (with a “normal” lease), building credit and saving for a down payment. Then, when they’re ready, they can choose from any home on the market in their price range.
Finding Rent-to-Own Homes
Numerous real estate aggregator websites such as Realtor.com, Trulia and Zillow make it easy – and free – to search for properties to buy or rent. If you’re in the market for a rent-to-own home, however, it can be a bit more challenging to find available properties. Two places to try are HousingList.com and iRentToOwn.com. Both of these websites have rent-to-own listings from across the nation – just enter your desired city and state or zip code to display a list of available properties. In markets with no current availability, a list of for-sale and for-rent homes may appear.
Be forewarned: Rent-to-own websites typically charge a “membership” fee to view any information beyond an exterior photo and the number of bedrooms and baths. HousingList.com, for example, charges "a nominal fee" for a seven-day trial, after which point you will be billed regularly per month unless you cancel (you must enter your credit card information to pay for the trial). iRentToOwn won't even tell you the fee until you register, providing both an email and a phone number. It's $1 for seven days, $99 for a three-month membership and $179 for an annual membership.
Another option is to ask sellers if they would consider a rent-to-own agreement. This is especially helpful if you’ve found your dream house, but you just can’t make the finances work out yet. Many sellers are open to such agreements, particularly in areas where homes spend a higher-than-average number of days on the market. In these markets, many sellers have already moved into their next homes – perhaps to relocate for a new job – and the longer the old home sits on the market, the harder it is to meet monthly debt obligations for two mortgages. In addition, many homeowners are leery – and rightfully so – about leaving a home vacant, especially for an extended period of time. As a result, these sellers may consider a rent-to-own agreement, even if the home is not listed as such.
You can also try working with a real estate agent in your desired market. Agents may have listings for rent-to-own homes, or may have inside information about sellers who may consider such agreements.
Renting vs. Owning a Home: Pros and Cons
If an owner is having trouble selling, rent to own provides an alternative to lowering the home's price, taking the home off the market, or renting the home out long term. Because a selling price is established in the lease-option contract, the current homeowner knows exactly what to expect if a sale goes through. If the market declines slightly during the lease period, the sale price is already locked in, but the tenant will probably still be interested in buying the property because of the rent credit. Meanwhile, the owner gets help paying the mortgage, property taxes and insurance. Also, the tenants are more likely to take care of a lease-option property because they have the option to purchase it.
The main reason why a rent-to-own agreement appeals to buyers is the financial one, of course – no need to come up with a substantial down payment or qualify for a mortgage. The buyer also does not have to worry about immediately coming up with the money for property taxes, private mortgage insurance or homeowner's insurance (though they should carry renter's insurance, as noted above). Furthermore, by signing a contract now, the buyer locks in a purchase price, which means no worrying about rising home prices. (Bear in mind, however, that in a rapidly appreciating real estate market, a savvy owner would probably want to add a clause to the contract allowing for the price of the home to increase, especially if the lease is for several years.) Finally, by living in the home before deciding to purchase it, a buyer has the advantage of a lengthy test drive on the home before jumping into a major financial commitment.
And the downside? Since it's less common, the rent-to-own process isn’t as tightly regulated as the home-buying industry or even the rental industry. While this lack of regulation can be a good thing, in that it gives would-be buyers and property owners more freedom in negotiating the purchase-option part of their contract (the lease agreement and purchase agreement are still subject to all the usual real estate laws), it can also make it easier for unscrupulous owners to take advantage of unsophisticated buyers. Sadly, the rent-to-own universe is rife with predatory landlords who have no intention of ever selling their property, and who are just trying to collect above-market rent and eventually make off with your nonrefundable option deposit. An owner could make the contract become void if the buyer is late on one payment or evict the buyer for not doing repairs. In one case in Florida, for example, a landlord with hundreds of properties negotiated contracts that permitted evictions for such items – with just three days’ notice.
In short, there's little that's "standard" in these legally binding contracts, making it especially important that you know exactly what you're agreeing to. In fact, not all states allow lease options on residential property, so the buyer should ensure that even entering into this sort of agreement is legal. Even if a real estate agent assists with the process, or you hire a real estate attorney to explain (and maybe even negotiate) the contract, if you can’t understand both the legal and financial aspects of rent to own, you are not a good candidate.
Understanding Rent-to-Own Contracts
Like any contract, your rent-to-own contract needs to state the name of the tenant-buyer (that’s you) and the landlord-seller and be signed and dated by both parties. If anyone besides you will be occupying the property, that person should be named in the rental agreement, too. The contract should also have a legal description of the property: the full address and the parcel number. Including the parcel number helps eliminate any potential confusion about the address. You can get this number from the local property tax assessor's office, often by simply looking up the address at the tax assessor’s website.
The lease portion of the contract should include everything you’d normally find in a property rental agreement. Key elements include:
- The start and end dates of the lease period, whether that period can be extended and under what conditions
- How much the rent is, when it is due, where payment should be made and what payment types the landlord will accept
- Fees, if any, for late rent or returned checks
- The amount of the security deposit, which should be fully refundable if you move out and haven’t damaged the property
- Whether and which types of pets are allowed
- Whether smoking is allowed
- A description of any parking spaces or other amenities
- Whether you can sublet the property, and if so, under what circumstances and terms
- Which utilities the tenant is responsible for and which the landlord is responsible for
- The conditions that can result in eviction, as well as the number of days you have to correct a problem before being evicted
A key difference between a regular lease and a rent-to-own lease is that under a regular lease agreement, the landlord will make and pay for all repairs and handle any routine maintenance. A rent-to-own agreement might make the tenant responsible for these items, the idea being that the tenant who intends to buy has a long-term stake in the property and should handle these tasks. Another possibility is that the landlord might not live nearby and it’s more convenient to make the tenant responsible.
However, until you actually own the property, you don’t want to be putting money into it that you might never get back. If the landlord won’t agree to handle repairs and maintenance, be wary. At most, you might agree to take on these responsibilities and expenses if they are added to your rent credit (which we’ll discuss in the next section). In other words, if you spend $1,000 to have some worn-out plumbing replaced, the seller will return that $1,000 to you at closing if you buy the place. But the risk to you is lowest if you don’t lay out the cash for these expenses in the first place.
The option provisions might be the most complicated – and double-edged – part of a rent-to-own contract. These are the provisions that can make renting to own the property more favorable to you than just renting – or that can make it easy for the seller to collect extra monies with no intention of ever letting you buy.
These provisions should state:
- The rent and what portion constitutes the rent credit
- The option deposit - Under some agreements, you might pay only an option deposit or only a rent credit, not both. It’s up to you and the seller.
- That you have the exclusive right to purchase the home at the end of the lease period - This means that the seller cannot let anyone else buy the property during the option period (basically, while you're renting the property). Make sure this period is long enough to give you a chance to correct whatever problems, like poor credit or lack of a down payment, that have made you unable to qualify for a mortgage right now. Eighteen months to two years is often a reasonable time frame; three years might be even better. The contract should state how many days’ notice you are required to give the seller that you intend to buy, and at what point your option to buy expires. You may want to structure the contract so that you can buy before the end of the lease period if your financial situation improves sooner.
- That the seller maintains homeowner's insurance, that he/she stays current with property taxes and that he/she doesn’t take out any new loans against the house - You don’t want the seller to be able to do anything that gives another entity a right to the property because, if that happens, it will be difficult if not impossible for you to buy it.
- Any other conditions, besides electing not to buy, under which you forfeit your deposit and rent credit --These might include vacating the premises, trashing the property or failing to pay rent as agreed - basically, the same things that could get you evicted.
The purchase portion of a rent-to-own agreement is similar to a regular real estate purchase agreement. Your state’s laws may require a standard contract for real estate purchase agreements. But even in a standard agreement, there's room to negotiate the fill-in-the-blank sections.
It will state the purchase price, which should be reasonable given current market values for similar properties. The seller might want to price the home 5% to 10% higher to account for price appreciation during the rental period. But keep in mind that home values could also decrease during that time. If that happens, not only might you not want to pay the price you originally agreed to, but a bank might not lend you enough for you to close the deal. In this situation, you will end up not exercising your option to buy, and you will lose your option deposit and rent credit unless your contract provides an alternative.
Let’s say the property is worth $200,000 at the time you’re drawing up the contract. You might be able to get the seller to agree to sell you the property for $210,000 or its appraised value at the time of purchase, whichever is lower. Whether the market increases or decreases, the price will be fair and the appraisal won’t prevent you from buying. Of course, these terms are highly favorable to you, the buyer, so don’t be surprised if the seller balks, concerned about taking a loss on the property or being unable to pay off his or her mortgage. So agreeing to a firm purchase price might be the only way to go.
The contract should explicitly state which appliances and fixtures come with the house if you decide to buy it. Do you get the dishwasher, the fridge, the washer and dryer? What about the patio furniture and all the potted plants? Don’t assume anything; spell it out.
Ideally, the purchase portion of the contract should also provide you with a remedy if the seller backs out. You’ve put down the equivalent of an earnest money deposit in the form of your option deposit; have the contract require the seller to not only return your option deposit and rent credit, but pay you an additional sum if he or she doesn’t uphold the agreement when you’re ready to buy. You may never collect the money, but it doesn’t hurt to try. And just having such provisions in the contract could act as a deterrent to the seller's reneging on the deal.
You also want to contract to give you an out, and give you your money back, if the title isn’t clear or if a property inspection reveals that the home is in poor condition. These are typical contingency clauses in a real estate purchase contract.
For protection, you should use an escrow service. This neutral third party acts as a financial intermediary between you and the landlord. It will hold your option deposit and monthly rent credits until you buy the property, at which point it'll return the money to you to put toward your down payment and closing costs. If the purchase option expires and you decide not to buy, the escrow service will remit those sums to the landlord. It will also turn over the money to the correct party in the event that either of you violates your end of the agreement in a way that can’t be remedied.
Potential Pitfalls for Buyers
Before signing that contract and entering a rent-to-own agreement, a potential buyer should:
Check the seller's credit report. Look for potential warning signs that the seller is in financial trouble, such as delinquent accounts or a large amount of outstanding debt. Even after a satisfactory credit check, a potential buyer who currently lives in the home should still pay attention to any warning signs that would indicate that the seller is in financial distress. Some examples include phone calls from debt collectors and suspicious-looking notices that are sent to the house.
Recognize that the seller could lose the property during the rental period. This could occur for any number of reasons such as if he or she is unable to make the mortgage payments, a tax judgment is placed on the property, he or she goes through a divorce, is being sued, and so on. If the seller loses the property, the potential buyer loses the possibility of buying the property, forfeits the extra rent paid and will have to find a new place to live.
Ensure that the lease option clearly states who is responsible for various types of maintenance or repairs. This agreement should also specify the types of changes or improvements (if any) the potential buyer is allowed to make to the property during the lease term.
Be sure to enter a "lease-option agreement" rather than a "lease-purchase agreement." The former grants the option to buy at any time during the rental period, while the latter requires purchase by the end of the lease period and has legal ramifications for backing out.
Do market research and obtain a home inspection and an appraisal. This is how you can ensure that the home purchase price is fair before signing a contract.
Be aware that if the seller is unscrupulous, he or she can refuse to sell at the end of the lease-option period. This means that all the above-market rent money you've paid will be lost. A seller may also try to back out of the contract if the real estate market has appreciated rapidly and the property significantly increases in value – or hold you up for more money. Of course, none of these actions are legal, but if the buyer doesn't have the financial resources to hire a lawyer, there won't be much recourse against a shady seller.
Understand that if the market declines, you will still have to pay the higher price stipulated in the contract to own the home. However, if the price is too high, the lessee can just walk away and shop for a different property. However, you'll will lose that portion of the rent that would have gone toward a down payment, so it's important to do the math necessary to determine whether walking away is the best option.
Talk to a mortgage broker to find out what it will take to qualify for a home mortgage in future. While inability to obtain financing or sufficient financing is precisely why many buyers opt for rent-to-own arrangements, you want to make sure there's nothing major in your credit history that could stop you from getting approved down the line. If you determine that you’ll still be unable to qualify for a mortgage by the time the lease expires, a rent-to-own agreement could become a costly mistake.
Obtain a condition of the title report. This can help a buyer learn how long the seller has owned the property. The longer the seller has owned it, the more equity and stability he or she should have built up in it.
The Bottom Line
Even though you’ll start off renting the property, it’s a good idea to perform the same due diligence you would if you were buying the property. Those who can afford to buy a home the traditional way, using financing, are probably better off doing so. But for those who just need to buy some time – or need to keep their options open or their funds liquid – renting to own can be a way to reside in your dream home now, and pay in full for it later
Source: Rent-to-Own Homes: How the Process Works | Investopedia https://www.investopedia.com/updates/rent-to-own-homes/#ixzz57fsRJPTc