What if a portion of your rent went toward a down payment on the property you’re currently renting? That’s precisely what renters can expect from rent-to-own homes.
Renting a home with the option to buy can provide a path to homeownership for those unable to qualify for a traditional mortgage. Rent-to-own agreements allow you to rent a property for a set period of time while building up a down payment to purchase the home eventually.
The U.S. rent-to-own home market is poised to grow from $10.48 billion to $15.53 billion by 2027. The growth is driven by millennials moving into populated metros across the U.S.
Rent-to-own agreements, also known as lease-option contracts, offer a mix of a typical rental agreement and the option to purchase a home in the future. They can be a practical option for those still getting ready for homeownership but want to work toward it while renting. It’s essential to fully understand the details of the contract before signing, as rent-to-own agreements can be pretty complicated and often favor the landlord rather than the tenant.
Like all investments, there are pros and cons. Understanding both sides of rent-to-own contracts will give you a leg up if you approach this unique real estate opportunity.
- A rent-to-own agreement allows a renter to lease a home for a specified period, usually 1–3 years, with the option of buying it before the lease expires.
- Four out of five Americans would consider a rent-to-own agreement, with millennials being the most interested demographic.
- Rent-to-own contracts are only for some but can provide a viable path to homeownership under certain circumstances, such as self-employed borrowers, first-time homebuyers, or those with atypical income patterns.
- Tenants should understand their lease-option contract terms, as forfeited down payment funds (if you cannot purchase the home) are common situations.
How Does Rent-to-Own Work?
With a rent-to-own agreement, a tenant can rent a property for a set duration, typically two to three years, with the possibility of purchasing it before the lease concludes. These agreements comprise a regular rental contract requiring monthly payments and an option to buy the property at a locked-in price.
At a glance, rent-to-own agreements are an intriguing option, as they allow renters to bypass typical mortgage terms by:
- Applying a portion of the rent to a future down payment
- Locking in a purchase price upfront
- Building equity and ownership during the rental period
However, rent-to-own also comes with obligations not found in typical renting. There are many nuances, with any deviation benefiting the landlord at the tenant’s expense. Make sure you fully understand the contract before signing it.
The option fee is 5 percent of the home’s $500,000 purchase price, or $25,000. You’ll pay that amount upfront, and your monthly rent is a predetermined $2,500. Your lender will put 20 percent of the rent ($500 per month) into an escrow account during the three years of your lease. When it comes time to purchase, you’ll subtract the $25,000 option fee and $18,000 in rent credits ($500 over 36 months), which reduces the purchase price by $43,000—bringing your $500,000 purchase price to $457,000.
6 Benefits of Rent-to-Own Homes
Pursuing the dream of homeownership can be an exciting and fulfilling journey. A rent-to-own agreement can offer unique and advantageous benefits for those who may need more time to be ready for a traditional mortgage. Rent-to-own agreements provide flexibility, allowing aspiring buyers to move into their desired home while simultaneously building a solid financial foundation to purchase it eventually.
When contemplating rent-to-own homes, there are many factors to take into account, such as:
- Locked-In Purchase Price: Signing a rent-to-own contract lets you secure the purchase price upfront. This protects you from the home’s value increase over the rental period, which is likely in many markets. The locked price provides certainty about the amount needed to buy it eventually.
- Building Equity While Renting: If you’re living in a rent-to-own home, some of your rent payments will be placed in an escrow account as “rent credit” for the future. This builds up equity and reduces the amount required for purchase. Additionally, specific option fees can be applied to the home’s principal. This means you will have a stake in the ownership of the house before the actual purchase date.
- Time to Improve Finances: The multi-year lease period allows you to improve your financial standing to buy. You can work on paying down debts, increasing your income and credit score, and saving for a proper down payment. Rent-to-own provides the runway to meet lender qualifications.
- Try Before You Buy: Renting the home first lets you live in it to ensure it truly meets your space and amenity needs before purchasing. You can avoid regrets and back out if the house doesn’t fit your lifestyle as expected when your lease ends.
- Less Money Needed for a Down Payment: The rent credits you accumulate in escrow reduce the amount you’ll eventually need to put down. This makes saving for a down payment more feasible. If you pay $300/month in rent credit for three years, that’s $10,800 less needed at purchase.
- A Flexible Path to Homeownership: Rent-to-own provides a transitional step to homeownership if you don’t currently qualify for a mortgage. You can live in the home as you work to improve your credit and financial footing. This flexibility lets you become a homeowner over time.
Key Steps in the Rent-to-Own Process
In a future home sale contract, the buyer and seller agree on a purchase price and terms upfront. Determining the accurate price and times can be challenging, particularly in shifting housing markets. For example, in a rising market, the seller may want the buyer to pay more than the current value.
Some contracts state that an appraiser will decide the fair market price at the actual time of sale. If this is the case, the buyer should ensure that the contract allows them to hire their own appraiser. Additionally, there should be provisions for resolving discrepancies between the buyer’s and seller’s appraisals.
To secure the future right to purchase the home, the buyer pays an upfront “option fee” when signing the initial lease. This fee is typically nonrefundable and ranges from 1–7% of the total agreed-upon purchase price.
For a $500,000 purchase price, the option fee could be anywhere from $5,000 (1%) to $25,000 (5%), depending on the negotiated amount. This allows the buyer to purchase the home once the lease ends.
Each month, a predetermined percentage of the rent payment goes into an escrow account as a credit to later apply toward the down payment at purchase. For example, if 20% of the $2,500 monthly rent is credited, that’s $500 added to escrow each month.
At the end of the lease period, when the buyer purchases the home, the accumulated rent credits and original option fee are deducted from the final sales price. This effectively lowers the total amount needed to buy the house.
Entering a rent-to-own agreement involves several key steps:
- Agree on a purchase price and terms with the seller.
- Pay an upfront “option fee” for the right to buy the house later.
- Make monthly rent payments, with a portion credited toward the purchase.
- Maintain the property and pay for repairs (in most cases).
- Obtain financing and buy the house before the lease expires.
When Rent-to-Own Agreements Make Sense
Rent-to-own agreements may not be suitable for everyone but can offer a feasible way to become a homeowner in specific scenarios, including:
- Irregular Income: People with nontraditional incomes, such as bonuses, commissions, or contract work, may have enough funds for a down payment but may need help to document a stable income for a mortgage. Rent-to-own provides time to establish a consistent income history.
- Self-Employed Borrowers: Self-employed borrowers may face higher income requirements and be required to submit more documentation. Rent-to-own agreements can provide additional time to gather and submit records to qualify for a mortgage.
- Relocating Renters: Rent-to-own contracts offer renters time to settle in and establish credit and income before purchasing a home in a new city.
- First-Time Homebuyers: First-time homebuyers may need help saving for a down payment or improving their credit to qualify for a loan. Rent-to-own agreements offer a solution by allowing them to secure a home while they work toward meeting mortgage requirements.
- Expats or Foreign Nationals: Foreign nationals and expats might only be eligible for a mortgage with a U.S. credit history. A rent-to-own contract allows them to establish a credit profile while residing in the home.
Rent-to-own agreements appeal to aspiring homeowners who:
- Don’t currently qualify for a mortgage
- Lack the funds for a standard down payment
- Need time to improve their credit score
- Want to lock in a purchase price in a rising housing market
Lease-Option vs. Lease-Purchase Agreements
Rent-to-own contracts come in two primary forms: lease-option and lease-purchase. The critical difference is in the buyer’s obligation to purchase the home.
With a lease-option contract, the buyer obtains the right but not the requirement to purchase the home when the lease expires. If the buyer ultimately decides not to buy, they simply walk away, allowing the lease to expire naturally.
On the other hand, lease-purchase contracts legally obligate the buyer to purchase the home once the lease term ends. The buyer is bound to follow through on acquiring the property, even if they no longer want or can afford it.
- A lease-option allows the buyer to purchase the home when the lease ends but does not obligate them to buy.
- A lease-purchase legally requires the buyer to purchase the home once the lease period is over.
- Both carry risks for the buyer, but lease-option provides more flexibility to walk away if no longer interested.
- With lease-option, the buyer loses any option money paid if they don’t go through with buying. However, they avoid being forced to close on a home they no longer want.
The Dangerous Downsides of Rent-to-Own
“You may not have much money now, but over the course of a year or multiple-year rental agreement, you are likely to spend tens of thousands of dollars on this place. Make sure you’re entering into something that is worthwhile instead of losing out on the back end.”Benjy Schirm, J.D.
Suppose you’re thinking about rent-to-own as a path to homeownership. In that case, it’s crucial to carefully consider the potential risks involved because they can be life-changing if poorly executed for a renter.
“Even with legitimate rent-to-own deals, the devil is in the details,” says FTC consumer education specialist Amy Hebert. She recommends most homebuyers pursue a traditional route, “Consider saving up your money and working on repairing your credit to buy a house down the road.”
Regarding rent-to-own, it’s essential to understand that the buyer takes on all potential risks. Please ensure financing or a decrease in home value to avoid the loss of your option fee and rent credits. Moreover, the locked-in purchase price may surpass the home’s fair market value at the end of your lease.
Rent-to-own agreements place unique obligations on buyers, such as being responsible for all maintenance and repairs. If you violate the contract, you could lose the ability to purchase the home and receive no refund for money already paid.
Rent-to-own may not necessarily speed up the process of homeownership and may instead delay it. If you cannot secure a mortgage within the lease period, the contract expires, and you’ll be left with nothing. Given the significant risks involved, it’s crucial to thoroughly review the terms and consider consulting with an attorney before signing a contract.
While the seller typically supplies a real estate attorney for the arrangement, it’s highly recommended that the homebuyer secures their own legal representation before any paperwork is signed.
Additional Risks to a Rent-to-Own Agreement
- Loss of Option Fee: The upfront “option fee” is usually nonrefundable. If you’re unable to complete the purchase, this money is forfeited.
- Loss of Rent Credit: If you don’t end up buying, any portion of rent paid toward the home purchase is lost. This money does not transfer back to you.
- Lower Appreciation: You take on the risk if the property value declines over the rental period. The locked-in price may exceed fair market value when the lease expires.
- Delayed Homeownership: Failure to obtain financing by the end of the lease term means you don’t buy the home as planned.
- Mandatory Purchase: With a lease-purchase contract, you may be obligated to purchase the property even if you no longer want to buy it or can’t secure financing.
- Maintenance Burdens: As the renter, you’re likely responsible for maintenance costs and repairs—expenses that fall to the landlord under typical leases.
- Loss of Option: Breach of contract, like missing a rent payment, can cause you to lose the option to buy the property—with no refund of fees/rent paid.
Rent-to-Own Homes Are a Win for Some, But Not Most
Rent-to-own arrangements may seem like an easy path to homeownership, but the lopsided contracts put tenants at substantial risk. These agreements often benefit landlords significantly more than buyers because:
- The multi-year leases lock tenants into purchasing at a preset price, even if the property later declines in value.
- Tenants bear all the risk of overpaying, while landlords offload properties for guaranteed returns.
- Forfeiture of nonrefundable fees and rent equity is common if financing falls through.
- Tenants are saddled with maintenance and repair costs usually borne by landlords. One missed rent payment can result in losing all accumulated equity with no recourse.
- The contracts are written to protect landlord interests while tenants undertake obligations and liabilities not found in typical leases.
If you are considering rent-to-own, it is vital to know that this arrangement can favor the property owner heavily. While it offers more flexibility than traditional renting, significant financial risks and a high likelihood of failure are involved. It is strongly advised that you proceed cautiously and seek legal advice from an attorney to fully understand your rights and liabilities before signing any agreements. Failure to do so could leave you worse off than when you initially began the process.
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