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How Does Rent-To-Own Work?

tl;dr

What You Need To Know

  • Rent-to-own arrangements help you save toward a down payment on the home you’re renting
  • Rent can be higher than market rates on rent-to-own properties, with the extra money going toward the down payment – if you buy
  • There are two main types of rent-to-own contracts, one type allows you to choose to buy and the other legally commits you to buy once your lease is up

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There are few reasons why a rent-to-own option may be a good fit. Maybe you’re not financially ready to make a large down payment. Or maybe you aren’t ready to take out a mortgage.

Rent-to-own agreements can help first-time home buyers, people getting their “financial act” together and anyone who is tired of the endless renting grind. 

With this unique rental option, you can work on a down payment and closing costs while avoiding some of the larger maintenance expenses you’d normally have when you buy a home outright. 

This nontraditional home purchasing method can provide some great benefits for people who want to buy a home but need just a little more time to get things in order.

Read on and get the facts on this innovative home purchasing tool. Better yet, use the guide to help you decide if rent-to-own might work for you.

What Are Rent-To-Own Homes?

Rent-to-own homes are rental properties that can transition to “for sale” properties under an agreement between the renter and the seller. 

It allows renters to gradually work their way into homeownership and essentially live in the house as a “test drive” before they buy it.

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.

The lease agreement can include a clause where the owner assigns rent credits to the amount you pay above the typical market rate. You can then use those credits toward a down payment on the house at the end of your lease. 

Some owners also charge an option fee, which is 1% – 7% of the home’s value. This is an upfront fee that’s sort of like a mini down payment on the home. It 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.

At the end of the lease, if you decide to buy, the homeowner transfers your rent-credit cash to your mortgage lender. 

But there’s a catch. If you pass on the option to buy, the property owner gets to keep your rent credit money. 

While that sounds like a pricey penalty to pay (and it is), the rent-to-own process has some substantial perks.

What Are the Benefits of Rent-To-Own?

This arrangement helps you save to become a homeowner, gives you time to boost your credit score, minimizes maintenance expenses and lets you try the house out before you buy.

An effective way to save toward a down payment

Saving money for a home can be a challenge. But with a rent-to-own, you’re handing over a fixed amount above market rent to your landlord every month. That is automatic saving – and those savings add up. 

Let’s say the monthly rent on your lease-with-option-to-buy is $1,700 and $350 of that is your rent credit. If the home’s purchase price is $300,000, at the end of a 3-year lease, you will have saved $12,600 toward the down payment. That 4.2% may seem small, but it can do big things, including potentially qualifying you for an FHA loan.

Allows you to work on your credit

If your credit is less-than-stellar, work on improving it during your lease period. It’ll save you lots of money in interest and lower your future monthly mortgage payments.

Say you finance the house with a loan for $287,400. 

A credit score of 650 might get you a 30-year fixed rate of 3.6%. That makes your monthly mortgage payment around $1,310.69, plus taxes and insurance. The total interest paid will be $184,448.92.

Let’s say your hard work gets that score up to 720. You could qualify for a fixed 30-year rate of 3.0%. 

That change in interest rate will drop your monthly payment by $99. You’d pay $1,112.69 and save $1,188 in a year. Ready for more? You’d save an impressive $35,640 in interest over the life of your mortgage loan. 

So, yeah, get that credit score up!

Provides you with an exclusive trial period

Most home buyers only get to walk through their future house a few times before they buy it. But rent-to-own arrangements allow you to live in the house, experience the neighborhood and learn about potential issues, quirks and concerns before you buy.

As a renter, you get to see it all: the possible termites in the attic or the neighbors with the kid who likes practicing Jimi Hendrix guitar riffs at 3 a.m. every morning. 

Makes repairs more affordable

Speaking of potential problems, consider the cost of repairs and other home maintenance items. 

A savvy renter can negotiate some helpful terms on that end. You can cover small repairs and have the owner take care of anything major while you’re leasing. Just make sure you get that arrangement in the agreement. 

What Types of Rent-To-Own Contracts Are Out There?

To better understand how rent-to-own works, you need to explore the two main types of contracts for these arrangements: lease-option and lease-purchase agreements.

They share some similarities, like offering a 1- to 3-year lease term and presetting a purchase price with the owner. 

The crucial difference depends on whether you’re obligated to buy or have the option to buy at the end of the lease.

Lease-option agreements: The name says it all

It’s in the name – you have the option to buy. Pretty simple, right? 

For the most part, that’s right. But there are a few things you need to keep in mind with lease-option agreements.

Many homeowners charge an option fee when you sign the agreement. It gives you the choice to buy or walk away at the end of your lease. Most option fees range between 1% and 7% of the property’s value.

You can walk away from the house at the end of a lease-option agreement – but it’ll cost you. If you walk away, you’ll end up losing both your rent credits and the option fee. 

The money will make up for the loss of the sale and the landlord’s costs to list the home, show the home and find another buyer for the home. 

If you decide to buy, you should make sure the purchase price you settled on at the start of the agreement is still reasonable. After a 2- or 3-year lease period, the housing market could have fluctuated, and the home’s value may have decreased. 

And don’t forget that you’ll need to get an appraisal to get a mortgage. 

Lease-purchase agreements are … We think you get the idea

This kind of rent-to-own arrangement locks you into a sales agreement from day one. 

The overall payment arrangements are the same. Rent credits add up over the lease period, and they’re applied to the home’s purchase price when you buy. 

At the end of the lease, you must purchase the home. If you don’t, you will lose your rent credit money, and you may face a lawsuit for breach of contract. 

Yeah, it’s that serious.

Set an initial purchase price with the seller before you enter into the contract. That helps you determine whether you can afford the house. Plus, you’ll need that information to shop for a mortgage loan.

What To Know Before You Buy

There are a few more things you’ll need to know to help you decide whether you should buy a home with either of the two types of rent-to-own contract agreements.

The best candidate

Who should think about a rent-to-own contract? There are no official criteria for rent-to-own buyers, but there are some common buyer traits:

  • Curious about homeownership, but not quite ready to commit
  • Committed to buying a home in less than 3 years (but no pressure!)
  • Can afford to make the elevated rent payments
  • Realistically able to qualify for a home loan at the end of the lease
  • Have a strong preference for where you want to live

You should also consider rent-to-own if:

  • You’re not financially ready to buy yet (but you’re getting close!).
  • You need time to establish or boost your credit score.
  • You’re hesitant about your ability to save for a down payment on your own.

The responsibilities

Although rent-to-own arrangements let you lower maintenance costs, they don’t eliminate them. It’s very likely the owner will want to share some of the repair costs with you while you’re under contract. 

Get it in writing and negotiate the best possible terms.

Better yet, talk to a real estate attorney. Remember, this agreement is initiating a real estate purchase. 

This is especially important with a lease-purchase agreement because you’re locked into a contract to buy. You’re buying a home. Don’t you want it to be in the best shape? 

Even if you have a lease-option contract, you stand to lose a lot of money in rent credits and option-fee payments if you walk away from the deal. So do your research. Make sure the home, the neighborhood and the loan type and terms are right for you before you sign a rent-to-own agreement. 

Bring in a lawyer. Schedule a thorough home inspection and have an appraisal performed.

Before You Sign on the Dotted Line

Here’s a final overview and brief recap of what you need to know before you put pen to paper. Yes, some of these may be a repeat. But that just means that they’re really important to remember!

  • Snag a real estate lawyer. Get a real estate lawyer. Hire a real estate lawyer.
  • Research the house and the surrounding area like your next paycheck depends on it.
    • Check out stats and data on the neighborhood: schools, crime rates, commute time, cost of living, unemployment rating, walkability and accessibility to grocery stores, restaurants, gyms, shops, parks and other businesses and amenities.
    • Review recent sale prices of comparable homes in the area.
    • Find out how long the seller has owned the home with a title search.
    • Check out the appliances and the home’s systems – like HVAC, security alarms, lawn irrigation and outdoor lighting – to confirm that they’re fully functional and well maintained.
    • Find out if there are any remodeling restrictions.
  • Carefully read and dissect the contract with your real estate attorney before signing. And make sure to dive into that fine print, too!

Is a Rent-To-Own Purchase Right for You? Yes, if You’re Ready

Financial readiness is the key to any real estate transaction. Rent-to-own is no exception. You’re signing a contract to eventually purchase a house. 

Even with a lease-option agreement, the assumption is that you’ll buy the home. That’s why walking away comes with costly financial penalties.

If you’re giving the option serious thought, think long and hard about the higher rent. Can you realistically afford to make those payments on time, every month for the 1 – 3 years you’ll be renting? 

If you need to work on your credit score, it’s important to take that under consideration. 

Depending on what needs improving, you may have to pay off credit cards and loans faster and keep your credit use low. Be prepared to rely on income, not credit, to buy the things you’ll need during that time.

If you feel confident about meeting these obligations, rent-to-own may be a good choice for you. 

And keep in mind that it’s not all sacrifice either. A home is one of the soundest investments you can make for your financial future. 

Say goodbye to the days when you helped build someone else’s equity with your rent money. You can use your rent money to own a home and grow equity in your own home instead!

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In Case You Missed It

Take-aways

  1. Rent-to-own agreements give serious buyers time to save for a down payment, boost their credit scores and prepare for homeownership
  2. Before signing a rent-to-own contract, research the home and the neighborhood – as you would for any home purchase
  3. Get an appraisal and revisit the purchase price at the end of the lease’s term before you buy (and make sure to include this in your contract)

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