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If you aren’t in a position to buy a home outright, you may be considering a rent-to-own property.
On its face, it seems like a win-win situation. You lock in a property while getting your finances in order to secure a mortgage. Plus, some of the rent you pay might go toward an eventual down payment.
But is there a catch? We’ll go over how rent-to-own works, the pros and cons and explain what you need to look out for in the fine print.
What Are Rent-To-Own Homes?
Rent-to-own means you have an agreement with the seller, giving you the right to purchase the property after renting and living in it. Whether or not you must purchase the home will depend on the terms of your agreement.
This option works well for people who are working on getting financially prepared to buy a home, but aren’t quite there yet. Ideally, renters will use this time to save up for a down payment, improve their credit and work on their debt-to-income (DTI) ratio.
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How Does Rent-To-Own Work?
Rent-to-own begins with an agreement between you – the potential home buyer – and the property owner or landlord. Both of you sign a lease agreement that includes an option or a promise to eventually buy the home.
Below are explanations of some of the most important elements of a rent-to-own agreement.
You and the seller can agree on a purchase price as part of the rent-to-own agreement. It’s a good idea to do this upfront, as it can save you the hassle of negotiating later – especially if there’s a sharp increase or decrease in the housing market.
To secure the right to purchase the home, it’s common to pay the seller an option fee. This is completely negotiable, so there’s no fixed rate, but they usually range between 1% and 7% of the home’s value.
The option fee protects you as the tenant and future home buyer, giving you the option to buy the house, as well as preventing the owner from selling it to anyone else while you’re on the lease. It also compensates the seller for not putting the house on the market.
Lease-option vs. lease-purchase agreements
There are two primary ways these agreements are structured: lease-option or lease-purchase.
Lease-option is a literal title, meaning you have the option to buy the house or not at the end of the agreement. Lease-option agreements are more favorable toward the buyer, as they give you additional flexibility.
A lease-purchase agreement locks you into purchasing the home. If you don’t, you could be sued for breach of contract.
Regardless of which option you choose, it can be a good idea to have a real estate attorney review the contract, so you don’t miss anything in the fine print.
It’s possible for part of the rent you pay each month to be applied to your eventual down payment on the house. This is called a rent credit.
This must be negotiated as part of the agreement between you and the seller. Generally, you’ll pay slightly above the market rate in rent in order for the seller to agree.
Be advised that if you have a lease-option agreement and decide not to purchase the house at the end of the lease, the seller gets to keep the rent credit money.
Should You Consider Rent-To-Own Property?
Here are some pros and cons to help you decide if rent-to-own is right for you.
PROS of rent-to-own homes👍
With rent credits, part of what you pay each month goes toward your eventual down payment. You also have the length of the lease term to focus on saving up as much as you can.
A common reason for choosing rent-to-own is if your credit score isn’t high enough to buy a house. The lease agreement secures your future home, while giving you the time to raise your credit score to secure a mortgage.
Depending on how your agreement is structured, you’ll most likely split repair costs with your landlord. If something breaks, you’ll have help versus if you bought a home outright.
If you lock in your purchase price and home prices rise during the years of the lease agreement, you could wind up getting a fantastic deal on a property.
CONS of rent-to-own homes👎
If you decide not to purchase the home, you’ll lose the option fee and potential rent credits. A 3% option fee on a $250,000 house would be $7,500. That’s a substantial loss.
To secure rent credits, you’ll have to pay rent that’s above the market-rate. This can make it harder to save money month-to-month.
The market giveth and it taketh away. If you lock in a purchase price and the housing market drops, you could end up paying more than the house is worth. Unfortunately, there’s no way to know ahead of time.
Unless you experience a windfall, you’ll likely still need to secure financing to purchase the home. If you can’t get a mortgage, you’ll have to move and lose the money you invested in the home.
Rent-To-Own Next Steps
If you think rent-to-own sounds right for you, here are some recommended next steps to take in your journey.
- Save for the option fee: For reference, 2% of a $200,000 home would be $4,000. While the fee is negotiable, it’s worth making a plan to save for it.
- Make a financial plan: Remember, you’ll likely need to secure a mortgage to complete the home purchase. Set concrete financial goals, like knowing how high you need to get your credit score.
- Find a property: There are several ways to do this, from searching online to asking friends and family if they know of any listings. A real estate agent can also be a tremendous resource.
- Negotiate with the seller: From purchase price to repairs, almost everything is up for negotiation. Make sure you know if it’s a lease option or lease purchase, what fees you’ll be responsible for and how repairs will be handled.
- Contact a real estate attorney: A lot goes into these agreements. For example, what happens if you’re late on a payment? Can you still purchase the house? We recommend consulting a real estate attorney to protect your best interests if you pursue a rent-to-own agreement.
Alternatives to Rent-To-Own
If the potential downsides of a rent-to-own agreement make you nervous, keep in mind that there are alternative paths to homeownership that might work better for your situation.
- U.S. Department of Agriculture (USDA) Loan: If you’re open to living in a rural area, this mortgage could unlock your new home. USDA loans also include perks like no down payment requirement.
- Federal Housing Administration (FHA) Loan: It’s possible to qualify for an FHA loan as long as your credit score is above 500.
- U.S. Department of Veterans Affairs (VA) Loan: Eligible service members and surviving spouses may qualify for a VA loan without a down payment.
FAQs about how rent-to-own works
You always need to be mindful of scams. But rent-to-own agreements are a perfectly legal route to homeownership that can be beneficial to both the buyer and the seller. Make sure to do your due diligence before signing a lease agreement and consider consulting a real estate attorney.
If you decide not to buy the home at the end of the lease agreement, you’ll lose the money you invested in the home. You could also overpay for the house if the market drops.
Generally, these agreements aren’t reported to the major credit bureaus. That means they can’t affect your score – for better or for worse.
Rent-To-Own Homes Aren’t Right for Everyone
If you need some additional time to save for a down payment and work on your credit score, a rent-to-own home could be the right move for you. Just keep in mind the potential downsides, and make sure you’re working to position yourself to qualify for a mortgage when the lease agreement ends.