Investment

Rent-To-Own Homes: How It Works

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It can take a long time to save enough money to buy a home or raise your credit score high enough to get desirable rates. In the meantime, you wind up renting, which means you’re typically paying someone else’s mortgage and not building equity.

There’s a third option, though: rent-to-own agreements.

In a rent-to-own agreement, you and the property’s seller agree to have you rent a home for a specified time period, with the option to buy before your lease expires. It may sound like the best of both worlds—and it is—for some aspiring home buyers and sellers. For others, it’s more complicated and costly than it’s worth.

In this post, we’ll cover the following:

  • What are rent-to-own homes
  • How do rent-to-own homes work
  • Who should consider renting-to-own
  • Pros and cons of rent-to-own homes

Let’s get started.

What Are Rent-to-Own Homes?

Rent-to-own agreements give you, as a renter, the option of purchasing a home after renting it for a determined time period, usually one to three years. When making rent payments, you’ll pay above the fair market value for the property. The extra money paid goes toward your down payment.

Sometimes, renters also pay an upfront “option fee,” which is 1-5% of the home’s purchase price. Option fees are somewhat comparable to earnest money, the good faith deposit you put down to show you’re serious about purchasing a home. Depending on your contract, this can also be applied to your down payment.

When your lease is up, you can either buy the home or walk away. If you walk away, the homeowner usually keeps the extra payments you’ve made.

How Do Rent-to-Own Homes Work?

The rent-to-own process is straightforward:

  • Step 1: Sign a rent-to-own contract
  • Step 2: Pay the option fee
  • Step 3: Rent the home until you’re ready to buy, or walk away from the deal

Apart from what’s outlined in your state laws, rent-to-own contracts can be set however you and the homeowner/landlord choose. For that reason, it’s really important for you to know exactly what you’re getting into before you sign.

There are two types of rent-to-own agreements: lease-option and lease-purchase. Understanding the distinctions between each can save you a lot of stress down the road.

Lease option agreement

A lease-option agreement gives you the option to walk away at the end of the lease. You’re often required to pay an option fee, but you can usually negotiate how much. Then, the extra rent money you pay goes towards your down payment.

Lease-purchase agreement

A lease-purchase agreement works similarly to a lease-option agreement, except you’re required to purchase the property at the end of your lease. If you fail to qualify for a mortgage, you’ll lose all of your rent credit and any claim to the home. The homeowner can also sue you for a breach of contract.

Regardless of your agreement, you’re usually required to get an appraisal before entering into a contract or while you’re leasing the property. The appraisal will give you and the seller an estimate of the home’s value and how much it could be worth if/when you take over the lease. You’ll also know how much you have to save up for a down payment and qualify for a mortgage.

Things to Do Before Signing a Rent-to-Own Contract

Rent-to-own contracts are incredibly flexible. Here are some of the main items you should negotiate:

Purchase price

Agree on a purchase price before signing a contract. The price could be the home’s current fair market value or the home’s predicted value. Whatever you agree on, that’s the price you’ll have to pay if you want to buy the home when the lease ends.

Get a home inspection

A home inspection helps identify the property’s condition, including any maintenance problems, safety issues, and potential repairs required. You’ll want to know if the roof needs $20,000 worth of repairs before signing an agreement.

Repairs, upkeep, and dues

The seller may require you to be responsible for common homeowner’s costs, like repairs, maintenance, property taxes, and HOA dues. Sometimes, you and the seller agree to divide up these costs. Whatever you decide, make sure these responsibilities are clearly outlined in your contract and have a real estate attorney look it over before signing. Also, you should clearly define what “maintenance” means, such as mowing the lawn or making vital roof repairs.

Research the home owner

If the seller has financial problems, their problems could become your problems. For example, if the bank forecloses on the property before you’re ready to buy, you’ll lose the money you’ve put into it. Run their credit report to make sure they’re keeping up with payments. Also, check the title to see how long they have owned the home. The longer they’ve owned, the more equity they have.

Determine how much rent goes toward your purchase price

How much rent would the homeowner charge a typical renter, and how much are they agreeing to charge you? The difference should be how much rent is going toward your down payment (or your down payment and repair costs or whatever else you negotiate). These numbers and what the homeowner is doing with the extra rent should be clearly outlined in your contract.

Agree on option fees

If you’re paying an option fee, how much will you pay, and is it going toward your down payment? If some or all of it isn’t, where is it going instead? Solidify these details before signing.

Who Should Consider Renting-to-Own?

If you want to own a home, but you’re not financially ready or can’t get a mortgage in a non-confirming loan market (ie, you need a jumbo loan), you might be an ideal rent-to-own candidate . These people also have at least one, if not all three, of the following things in common:

  • You know exactly where you want to live. Whether it’s a neighborhood or an exact home, rent-to-own leases are best for people who know where they want to buy.
  • You need time to save for your down payment or boost your credit. These are two of the biggest barriers to entry for aspiring homeowners. Your credit score impacts your ability to get a mortgage and a desirable interest rate. The larger your down payment, the lower your monthly mortgage payments will be. If you can save at least 20% down, you can also avoid private mortgage insurance (PMI), further saving you money.
  • You have problems saving money. Budgeting isn’t easy. Sometimes knowing that a few hundred dollars every month will go toward your down payment helps ease your burden and make it easier to save for the rest.

If you’re not sure where you want to live and have no idea if you’ll have good credit and qualify for a loan before the end of the lease, renting-to-own is not for you.

Rent-to-Own Homes: The Pros

Is renting to own right for you? Here are a few more benefits to approaching homeownership this way:

no competition

Seller’s markets can be anxiety-inducing. In 2021, it wasn’t uncommon for eager homebuyers to offer $50,000 or even $100,000 above asking. Rent-to-own agreements cut out competition. If you sign a lease-option agreement, whether you want to buy or not is up to you.

You’re building a down payment

While your monthly rent payments are higher, you’re also building equity in your home in the form of a down payment. At the end of the lease, your down payment is partially covered. If you agree to pay $300,000 for a home at the end of a 3-year period, and $500 a month is going toward your down payment, you will have saved $18,000 over three years or 6% of a down payment.

You can save money on repairs

If you and the seller agree to split responsibilities, you can save money on repairs you’d otherwise be fully responsible for. You can also work with the seller to get the home in pristine condition before taking over as the homeowner.

Rent-to-Own Homes: The Cons

Here are the main drawbacks of renting to own:

You could pay above fair market value

No one can predict the future. If you agree to spend $25,000 above the home’s fair market value in three years, and the home drops $10,000 instead, you’re still required to pay what’s determined in your contract. If the home’s value increases by $75,000, you’ll still only pay what’s in your contract.

You’re tied to the homeowner

If the homeowner’s financial situation tanks and the property goes into foreclosure, their mortgage lender or bank assumes ownership, not you. When that happens, you’ll have lost the money you put into the property.

If the homeowner decides they don’t wish to sell, you’ll have to take legal action. You may win and recoup your money, but legally enforcing a rent-to-own agreement gets expensive.

Rent-to-own contracts favor the seller

Irrespective of your terms, sellers usually have most of the power in a rent-to-own agreement. They have lots of ways to get out of the deal, such as paying rent late or not making or paying for repairs within a reasonable timeframe. It’s unfortunate, but it’s true.

Final Thoughts

Rent-to-own homes aren’t for everyone, but they’re perfect for some. If you’d like to learn more about rent-to-own options, check out our articles on how to profit from a lease purchase and when you should and shouldn’t consider rent-to-own investing. Also, scroll through our forumswhere thousands of real estate experts can answer any questions you may have.

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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.

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