With the dream of homeownership out of reach for many Millennials in debt, the appeal of renting to own sounds like an alternative, achievable dream. Instead of “throwing away” thousands in rent while struggling to save for a down payment, your rent money goes toward the price of the home. So people always ask, how does rent to own work?
Rent to own, which is also known as a lease purchase, is a contract between you and the seller to buy a house at a future closing date. This can be anywhere from one to three years after the contract is signed. Only 1% of first-time home buyers were renting to own last year according to the 2016 Profile of Home Buyers and Sellers published by the National Association of Realtors.
Rent to own is different than a lease option, which gives you the option to buy a place you were renting before it goes on the market, but there’s no obligation to do so. When you rent to own you usually make a deposit, which can also be called “option money,” and the contract stipulates your obligation to buy. The deposit goes to the seller and is a non-refundable fee.
There’s no standard rate for option money, which can range anywhere from 2.5% to 7% of the total purchase price of the home. If you were buying a home for $250,000 and paid a 3% option consideration, you would pay $7,500 up front. It’s smart to have that money go toward to purchase price at closing so make sure it’s included as a clause in your contract.
The contract will specify the home’s price at market value or a bit higher. Some contracts will set a price for when the lease expires based on expectations of future market value. It’s usually advantageous to set the price at the market value when you signed the contract just in case the market value increases.
The rent is usually used toward the purchase price of the home. Some contracts state that only a percentage of the rent payment goes toward the purchase price.
For example, if you’re paying $1,400 a month on rent for 4 years and 30% of that goes toward the purchase of the home, you would’ve paid $20,160 toward the purchase price ($1,400 x 0.30 = $420; $420 x 48 months = $20,160).
Your contract may state that you, as the buyer, have to pay for repairs, homeowner fees, property taxes, and insurance while renting. Other contracts will stipulate that the current owner (the seller) covers these costs. It’s important that your contract clearly state who will cover repairs, because you might get stuck fixing a water leak on a home that isn’t legally yours yet. You should still have renter’s insurance to cover any issues in the interim.
Buying the Home
If you can’t buy the home because you’re unable to secure financing and your contract said you were legally obligated to buy, you will have to go through legal proceedings. If you weren’t legally obligated to buy, then your option expires and you forfeit the money you paid.
If you want to buy the home and you successfully secure a mortgage, then you pay the seller and you become the homeowner. Congratulations!
The Pros and Cons of Rent to Own
The rent to own option is appealing to many first-time homebuyers whose credit isn’t good or who can’t afford to save for down payments. When things sound too good to be true, they usually are. So what are the pros and cons?
Pros of Rent to Own
- You don’t need to have 20% saved for a down payment before you buy. This amount is out of reach for most people who are paying off student loans and credit card debt given that the median home price is over $318,000, which means you’d put $63,600 down.
- Your rental payments act like an investment. Instead of “giving away” your rent on a home you are temporarily staying in, your rent goes toward the purchase price of the home.
- You get to try before you buy. You can live in the home to make sure you love it before you buy it.
- You can improve your credit score and save more for a down payment. If your credit isn’t great, you have a few years to pay down debt and improve your credit before applying for a mortgage.
- You could get a great deal on a home if the market value increases while you’re renting it. This is a best case scenario and one that can happen if you research locations and follow market trends.
- A well-structured contract can evenly distribute the risk between both parties so that you (as the tenant) don’t hold most of the financial risk.
Cons of Rent to Own
- The arrangements can be very complex and it requires a detail-oriented person to read through all of the fine print.
- It can be unclear who is responsible for repairs while in the rental period — is it the current or future owner? Who pays the property taxes? You need to make sure these factors are clearly stated in the contract.
- Is 100% of your rent payment being credited toward the purchase of the home or only a part of it? This will determine how much you’ll owe on the house.
- You can lose your entire investment if you miss a payment or two. With mortgages, if you miss a payment, your credit score drops and you don’t lose any of the equity on the home. With a rent to own contract, you can forfeit all of the money you’ve put toward the home.If the houses in your area start to decline in value, you risk having bought a home that isn’t worth as much as you thought.
- You also need to make sure you qualify for a mortgage in order to afford the remainder of the payments on the home. If it’s time to buy and you don’t qualify, you forfeit your option-to-buy fee and the premiums.
- If the seller fails to pay the existing mortgage, he or she may foreclose on the home and another buyer could purchase it. That would leave you searching for a new place within 30 days.
Where You Can Rent to Own
Check out websites like IRenttoOwn.com and RentUntilYouOwn.com where you can search rent to own homes. Most likely, you’ll find homes offered at a lower price than others in the market. Every state has different laws for rent to own properties and some will protect you if you fall behind on your payments due to job loss or some other scenario.
Does renting to own sound like the right choice for you? Make sure to research your options and understand your state’s laws. It’s advisable to have a real estate broker review your rent to own contract, too, so you can make sure the agreement is fair and you’re not shouldering too much of the financial burden.