Rent-To-Own Homes: A Detailed Guide
If you’re out in the market for a new house, it might look like a tough road. You need to ensure you have a good enough credit score in order to qualify for a mortgage. However, What do you do if you don’t want to deal with all of that or just don’t like the idea of going into debt?
For that, there’s an alternative called ‘rent-to-own’ agreement. How does this help you? A rent-to-own agreement allows you to live in a house on rent while giving you the option, but no obligation, to buy the property that you’re currently paying rent for. There are two ways to go about a rent-to-own agreement: A standard lease agreement, or lease-purchase, and an option to buy, or lease-option.
In this article, we’ll be talking about the ins and outs of rent-to-own homes and cover all that you need to know and the pros and cons of this agreement for when you’re selling as well as buying a house.
How Does A Rent-To-Own Agreement Work?
A rent-to-own agreement requires the buyer and the seller to enter a contract wherein the buyer rents the property and the seller acts as the landlord. For the period of the lease, the buyer can live in the concerned property and pay rent, with the opportunity of buying the property at the end of the lease. Let’s look at the different components that go into a rent-to-own agreement:
Lease-Option And Lease Purchase
Whether there’s an obligation to buy the lease or just an option is dependent on the kind of contract drawn between the two concerned parties. While the rent-to-own agreements are classified into two categories, there are varying types of contracts wherein some are much more consumer-friendly than the others. Here are the major differences between the two categories:
Lease-purchase Agreement: These put the renter/buyer under the obligation of buying the property at the end of the lease period.
Lease-option Agreement: This agreement states that the renter has no obligation to buy the property at the end of the lease. If you’re renting, you might as well choose to not purchase the house. However, you might have to forfeit any money that you might have paid as upfront fees.
Also See: How to Renew a Rental Lease
In a rent-to-own agreement, the buyer has to pay a non-refundable fee to the seller. This fee is to be paid upfront and is generally stated in the contract under names option fee, option money, or option consideration. This upfront fee is the biggest difference between a normal lease and a rent-to-own lease as it gives the buyer the power to buy the property at the end of the lease.
This fee is often negotiable and is decided by both the buyer and the seller. Typically, upfront fees might fall in the range of 1% to 5% of the purchase price.
Purchase Price And Rent Credit
The purchase price of a property under a rent-to-own agreement is decided based on various factors instead of just the current market value of the place. In some situations, the price might be decided at the end of the lease, mostly dependent on the value of the property at that time. In other cases, the seller and buyer might reach an agreement to ‘lock in’ a price at the time of signing the lease. In this case, the price of that property is decided on the predictions of what the price might be at the end of the lease. However, it’s generally a little over the market value of the place at either time.
Talking about the rent you’ll pay under this lease, you have two ways of setting up payments. On one hand, you can start paying for the property with every rent payment, where a part of your rent is a premium that goes towards the premium for the house. If you choose to go this way, the rent will be slightly higher than the going rent for the area.
On the other hand, you can choose to pay for the place after the end of the lease. If you choose to go this route, you’ll have to manage finances as you would otherwise, and you’ll have to give up on any rent credit that you might have accumulated if you chose to pay for the house along with your rent.
Purchasing A Rent-To-Own Property
The terms of the purchase of a rent-to-own property are partly dependent on the terms of the agreement that was signed; if you have signed a lease-option contract, you’ll have to arrange for full finances, in the form of a mortgage, or any other source of capital in order to buy the property.
However, if you decide to not buy the property, you have the option of not purchasing the property with no obligation to do otherwise. However, this will mean that you’ll have to forfeit the entirety of the upfront fees as well as any rent credit that you might have collected over the period of the lease.
Conversely, if you have a lease-purchase contract, you’ll be legally obligated to buy the property in question. If you cannot manage to gather finances due to any number of reasons, you might be at the risk of getting sued. Due to these factors, a lease-option agreement is generally more preferred over a lease-purchase agreement.
Rent-To-Own Housing Process
The process of owning a rent-to-own property is much more than just different types of rental agreements. There are a few things that you need to keep in mind before you get into a rent-to-own agreement. We’ve condensed the entire process down to a few points. However, when you do start this process for your own home, make sure you do the due diligence and understand as many nuances as you can.
Scrutinize The Rent-To-Own Agreement
The first step to having a fully functional rent-to-own agreement is to sign a contract with the homeowner that clearly states the value of the home and the validity of the lease.
This contract should also contain information about the time frame of the lease within which you’ll have to declare your decision about the purchase of the property along with the terms of payment.
This contract should clearly state whether you’re going in for a lease-option or a lease-purchase agreement as well as the upfront fees and the future of the rent credit, should you choose not to buy the property.
Another thing that you need to look for is the maintenance reports along with the terms and conditions of maintenance of the property while it’s under lease. You need to be very clear about who is responsible for the upkeep of the property and the repairs beyond the normal wear and tear.
You need to be extra careful with this part since some local governments require the landlord to take care of certain things as a law. So, be extra careful. If you’re not very sure, consulting a real estate attorney might be a good idea.
Home Inspection And Appraisal
Entering a rent-to-own agreement is as good as buying the property, in essence. So, in order to make sure that you have not dug yourself a house-sized hole in your pocket, it’s very important for you to make sure that the property you’re looking at is in good shape.
One of the best ways to do that is to get the property appraised by an independent appraiser of your choosing. This will give you a proper market value of the property and help you decide the purchase price at the time of signing. However, once the price is locked, you’ll have to honor the contract even if the value of the property falls over the validity of your lease.
The bigger con is that if you’re financing this purchase through a lender, you’ll mostly receive the current market value of the property, meaning you’ll have to pay from your own pocket to meet the price in the contract.
Another important aspect is to get the home inspected before you hand over any money. In fact, if the homeowner allows, you should get a home inspection before signing any agreement. This will protect you from becoming the owner of a property that requires heavy, pocket-draining repairs.
You can also look into the details of the property and its owner by looking for the tax bills, the title of the property, mortgage statements, and other bills. Make sure you are very thorough with every aspect of your inspection in order to protect yourself from any loss or scam in a rent-to-own agreement. You may read our Blog on Importance of Home Inspection.
Payment Of Option Fees
Option fees, option money, or upfront fees are all names for fees that you pay at the time of signing the lease in order to give you exclusive access to the property when it hits the buyer’s market at the end of your lease.
Typically, if you decide to buy your house at the end of the lease, this fee is added to the purchase price of the house, giving you a 1% to 5% cushion with the purchase price. However, this fee is entirely forfeited if you choose to back out of the purchase.
One way to avoid paying any sort of fee upfront is to enter a lease-purchase agreement. Since this lease does not give you the opportunity to back out of the purchase at all, a lot of landlords do not ask for an option fee at the time of signing.
Purchasing The Property
Once you enter a rent-to-own agreement, there are a few more things that you need to be mindful of. The first one is that any delay in paying your rent can become the reason for the contract becoming void. Moreover, even the smallest inconsistencies as a tenant can affect your contract to some extent, if not void it altogether. So, make sure you secure the deal on all fronts.
Considering you’ve reached the end of your lease, now is the time for you to look into the financing options to make your purchase. This process is very similar to the one you would follow if you were a regular home buyer.
Make sure you choose the ideal lender for your mortgage and that you have an attorney on speed dial, should you need any consultation. Once the lease is up and you have started payment, you can use up the rent credit and upfront fees as a little push towards owning the property.
Pros And Cons Of Rent-To-Own Homes
As a Buyer
- Rent-to-own agreements are great for people who are in the real estate market but struggle with a low credit score or debts as it lets them work towards their home while boosting their income and building credit.
- With a locked-in purchase price, the buyer can walk into a huge profit if the going price of the home has increased at the end of the lease.
- You might have to give up on a big chunk of money in the form of rent credit and upfront fees if you do not buy the house.
- You might have to pay more than the value of the house if you lock a price at the time of signing and the value of the property decreases.
As a Seller
- Rent-to-own agreements help in widening the pool of potential buyers for a house.
- The seller might make some extra money if the tenant refuses to buy the house and forfeits the credits.
- The tenant will take better care of the house if they’re investing in it to own it.
- It’s a bit of a gamble for the seller since the tenant can back out of the deal or may pay less than the market value of the home because of a locked price.
- A seller might get stuck with the property they’re trying to sell if the buyer backs out at the end of the lease.
- Even if the deal goes through, the seller might not receive a large amount of money as the buyer will have credits as well as mortgage payments.
Also Read: Buyer’s Market vs Seller’s Market
Purchasing a house under a rent-to-own agreement is a big game of considerations. Would you love the home after the end of your lease? Would it be big enough to accommodate your lifestyle in the future? Would you be able to manage finances at the end of the lease? These are some of the easier things that you’ll have to consider.
Once you do, though, you’ll realize that you have a great opportunity of saving for a down payment or gathering some credit while you actively test the spot for living. While there are enough pros and cons of having a rent-to-own home to keep you busy for the entirety of your lease, make sure you do all the due diligence required before you take ownership of your new house.
FAQs For Rent-To-Own Homes
Why Is Rent-To-Own Bad?
Rent-to-own homes are a significant risk to buyers. If the contract is voided or the property gets foreclosed on, you’ll be forced to leave. Moreover, you also run the risk of getting into a bad deal if the value of the property fluctuates in a bad way.
What Credit Score Do You Need To Rent-To-Own A House?
While there is some tolerance in terms of the credit score, typically a minimum credit score of 620 is required in order to secure a rent-to-own house.
Is Lease-Purchase A Good Idea?
A lease-purchase agreement is a contract that requires the tenant to buy the house after the lease expires. While this might be a bad idea for the renter, it might be a great deal for the seller as they’re in for a pay-off at the end of the lease along with a consistent monthly income.