How does rent to own work?
Many of us dream of owning a home, but obtaining financing for that home may pose challenges. Before qualifying for a mortgage, you'll need to maintain an acceptable credit score while saving thousands of dollars for a down payment. In addition to real estate agent commissions, appraisal fees and title searches, standard mortgages and their associated costs might prevent you from getting a foothold in the housing market.
Meanwhile, renting a place can seem financially wasteful, with monthly payments going nowhere towards building wealth. Luckily, the decision to rent or buy a home isn’t as binary as it seems. If you need some time to strengthen your finances but want to get the ball rolling on homeownership, rent to own homes might be a good option.
What is rent to own?
Rent to own homes allow you to rent a property before opting to buy, giving the buyer a little more time and flexibility to build on their finances before applying for a mortgage.
The standard rental agreement requires you to make monthly payments throughout the term of the lease. For some rent to own properties, a portion of this monthly payment can go towards the homebuyer's down payment for the purchase of this home.
The portion of these rental payments are written within the initial contract between you and the seller. Depending on current market trends and the seller's eagerness to move, the rent credit (towards down payment) each month can range widely between contracts.
When it comes time to buy the property, you will have had ample time to bring up your credit score, while building on the finances you’ll use for the home’s down payment.
At the end of the rental period, you’ll be able to use the added rent credits to take an ownership stake in the home. The remainder of the home’s cost is usually covered by a lender through a mortgage loan.
Benefits of rent to own homes
Rent to own homes also offer an opportunity to build financial stability and provide you time to improve your credit score throughout the course of the lease. It’s possible to rent a home with bad credit, but sellers typically view a lower credit score as higher risk. Just like with mortgage lenders, bad credit, a short credit history or other debts could prevent the agreement from moving forward.
However, rent to own agreements don’t require mortgage approval right away. This gives you ample time to improve on a bad credit score before shopping for a loan. If approved to sign the lease, the long term financial commitment might make you a stronger candidate for mortgage approval.
If the immediate costs of buying a home are preventing you from applying for a mortgage, renting to own also might be a good option. While these agreements do include some upfront costs, they are not generally as steep as those associated with buying a home. During the rental period, you’ll have time to put money down towards the purchase while saving for the costs of eventually closing the sale.
When approved for that mortgage, the previous owner hands over the deed as the lender places a lien on the property, using it as collateral to ensure repayment of the loan.
Risks of rent to own homes
Rent to own agreements outline a purchase that might happen after a given amount of time. The uncertainty of some rent to own agreements leaves room for additional problems to arise throughout the course of the lease. Changing economic conditions, damage to the property or missed payments by the buyer can alter the outcome of these contracts. Since the benefits of these agreements depend on these external factors, the terms of rent to own contracts can vary widely.
To make up for this uncertainty, certain aspects of rent to own contracts are highly negotiable. In addition to the amount paid towards equity each month, factors such as closing costs and the home’s sales price are usually settled based on the finances and economic goals of the buyer and seller.
But what if the lease ends and you decide not to buy the home? Depending on your contract, opting out of the purchase might not be allowed. Before agreeing on a contract, it’s important to understand the main types of rent to own agreements and what they can mean for you down the line.
Types of rent to own agreements
Before signing that rent to own contract, make sure you fully understand the final terms of the contract. The two most common rent to own agreements differ in that one will allow for the option to opt out of buying the home at the end and the other may make you legally obligated to purchase the home. The two type of rent to own agreements are:
- Lease option agreement
- Lease purchase agreement
Lease option agreement
Rent to own properties with a lease option agreement grant you the option to buy the home when the lease is up, but won’t obligate you to purchase the property.
When signing a lease option agreement, you’ll pay the homeowner an upfront cost known as an “option fee.”
Usually falling within 1%-5% of the home’s sales price, an option fee secures your right to purchase the home after an established period of time.
After years of paying rent on a property with the aim to one day own it outright, you’ll want some assurance that the home won’t be sold to someone else in the meantime. Option fees prevent the seller from accepting another offer on the home while ensuring your right to make the initial bid.
These fees are usually negotiable and can be worked into the home’s eventual sales price. Depending on the terms of your agreement, option fees might be non-refundable if you decide not to purchase the property.
When the lease expires on a lease option agreement, you and the seller would negotiate a price for the home, usually after scheduling an appraisal of the property.
Depending on the terms of your contract, your option fee and any funds accumulated through rent payments can go towards the purchase price of the home. You’re still free to walk away from the sale, but doing so would forfeit the amount paid for the option fee.
Lease purchase agreement
Much like a lease option agreement, lease purchase agreements involve renting a property for an established period of time. However, rather than negotiate a sales price at the end of contract’s term, lease purchase agreements settle on a sales price when the agreement is signed.
In a lease purchase agreement, you will be responsible for funding the purchase of the home. That means securing a mortgage loan before the lease’s term is up. Since you already established the purchase price when signing the contract, you’ll have all the information you need to start looking for the right lender as soon as you start renting.
If the home’s price is expected to rise, locking in a sales price through a lease purchase agreement can also help the buyer save thousands in the long term. When it’s time to buy the home, you’ll be able to purchase the property at the price that was established when you first moved in, rather than pay for the home at its current value.
There are substantial benefits to signing a rent to own agreement, but it’s vital to thoroughly understand the terms of your contract and how your monthly rent payments are being distributed before signing the lease.
To find out if renting to own might be a good option for you, start by learning more about credit reports and what they reveal about your eligibility for a mortgage.