Rent-to-Own Homes 2021

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What You Should Know

  • A rent-to-own agreement allows you to rent a house for a period of time, after which you have the option of buying it
  • The option fee is how much you pay for being able to choose if you want to purchase the house or not
  • To save for the future down payment of the house, the tenant usually pays an extra amount of money every month on top of their rent
  • The purchase price of the house is determined when the contract is signed or when the lease expires and it is based on the current value of the house or some expected future value
  • In a lease-purchase agreement, tenants are obligated to purchase the house at a certain point, even if they can not qualify for a mortgage

What is a Rent-to-Own Home?

In a rent-to-own agreement, you rent a house for a period of time after which you have the option to buy it when the lease expires. This arrangement gives you the opportunity to build your credit score and save for a down payment so that it is easier for you to get approved for a mortgage at the time you decide to purchase the house.

Rent-to-own agreements are more popular in places where sellers find it difficult to sell a home. Instead of waiting for someone to be interested and have the financial means to purchase their home, home sellers resort to rent-to-own arrangements. While only certain agreements guarantee the purchase of the house at the end of the lease period, most rent-to-own agreements include fees that in some cases the seller is not obligated to refund such as when the tenant chooses not to exercise the option to buy.

While this might sound like a good solution for folks who want to become homeowners but are not financially ready yet, it’s important to note that rent-to-own homes come with a lot of costs and terms to the agreement, which you need to be aware of before you get into this arrangement.

How Does a Rent-to-Own Home Work?

Rent-to-own agreements consist of a lease agreement and an option to buy the home at the end of the lease agreement. Since there is an option to buy and the tenant will be a potential buyer at the time, there are a few more requirements in the rent-to-own lease agreements than in regular ones.

Lease Agreement

The lease agreement on a Rent-to-own home is very similar to a standard lease contract. This means that the lease specifies its duration, the amount of rent you will have to pay, and the responsibilities the tenant has. The rent in rent-to-own agreements is typically higher if you agree to use a portion of it towards the principle of the house, meaning that your monthly payment will include the usual rent plus a sum of money that will be saved in order to buy the house in the future. The title of the house in a rent-to-own agreement is still under the landlord’s name until the tenant actually buys the house. It is important to understand the terms of the lease agreement and figure out exactly what you will be paying for during the time you live at the house and what you might lose if you choose to not purchase and walk away from the deal.

Option to Buy

The option to buy the house at the end of the lease term provides a lot of flexibility to you since you have the right but not the obligation to purchase the house. This option presents a lot of risk and uncertainty to the seller, which is why the option comes at a cost that is typically non-refundable. Whether the option to buy is included in the lease agreement or set up as a separate document, it must include the following:

  1. The option fee - how much you will pay for the right to purchase the house
  2. The duration of the option period - the time during which you can decide to purchase the home
  3. The price for which the tenant will purchase the property in the future - what you will pay if you exercise the option to buy

Costs in a Rent-to-Own Agreement

While rent-to-own agreements can provide you with a lot of flexibility, you need to be certain that you want to purchase the house at some point down the road in order to make the costs of this arrangement worth it. Otherwise, if you are not sure about the house, it would probably be smarter to simply rent a place and look for a home when you are financially ready. Some of the costs associated with the rent-to-own agreement include:

Upfront option fee

The option fee determines how much you pay for the right to purchase the house during the option period. Since sellers take on great risk by giving you this option, they would need to have some sort of deposit that they can use to cover costs associated with you not buying the house. There are no rules on any price floor or ceilings related to the option fee, but the fee usually ranges between 1% and 5% of the purchase price of the house. You should try to negotiate the option fee before agreeing to the stated amount.

If you purchase the home, the option fee is counted towards the principal of the home, meaning that the sale price of the house will be reduced by the amount you have paid for the option fee. In certain cases, the option fee is non-refundable, such as when you don’t buy the house.

Rent Credits

Rent-to-own agreements also have a built-in savings feature that takes a portion of your rent to be used towards the future down payment on the home or against the price of the home. These are called “rent credits”. This is often a portion of your monthly rent payment, usually 25%. Most rent-to-own homes will have a higher monthly rent than regular homes for rent, but the extra amount that you will be paying each month will be used as an imposed savings. This forces you to save up money, which might be helpful for those who might otherwise have unhealthy financial spending habits.

However, while some rent-to-own agreements allow your rent credits to be refunded to you, which allows you to use them as a down payment, this may not always be the case. Some agreements might have the rent credits be applied against the price of the home, meaning that the price will be reduced by the amount you have paid in rent credits. In that case, the rent credits do not serve as a substitute for a down payment. You will still need to save up for a down payment if your rent credits are not refundable.

Maintenance and Repairs

When you are renting, your landlord is usually responsible for the cost of maintenance and repairs. However, with rent-to-own agreements, this is not always the case. Since there is a possibility that the tenant will own the house in the future, some sellers find it reasonable to hold the tenants accountable for maintaining and repairing the house.

You need to make sure that you fully understand what you are responsible for before signing a rent-to-own agreement. Major repairs such as updating the house’s electrical system can cost thousands of dollars, and if you do not purchase the house, you will have invested a lot of money in repairs that you will not keep.

Apart from being clear on the terms of the rent-to-own contract, it would also be a good idea to get a home inspection prior to signing an agreement. A home inspection can uncover the issues with the house that you yourself might not notice. An inspection will also reveal if the house will need any major future repairs. This can give you the upper hand in negotiating the purchase price of the house.

Types of Rent-to-Own Agreements

A Rent-to-Own agreement can either be a Lease-Option or a Lease-Purchase.

  • A Lease-Option agreement combines a standard lease contract with an option to purchase the home. An option is not an obligation. You are not forced to purchase the home at the end of your rental term. However, while you can choose to not purchase the home, you will probably lose any rent credits that you have saved up. You can purchase the home at any time up until the end of your rental contract. After the contract expires, you lose the right to purchase the home. Your landlord can then put the home up for sale or find other buyers.
  • A Lease-Purchase agreement combines both a standard lease contract with a purchase contract. With a Lease-Purchase, you agree to purchase the home at the end of your rental period. If you do not purchase the home, you can be liable for breaking the contract, even if the reason for not purchasing is that you cannot qualify for a mortgage. Since you are locked into purchasing the home, you may want to make sure that you are able to qualify for a mortgage by getting a pre-approval and that you are certain that you would like to purchase the home.

How is the Purchase Price Decided?

The purchase price of the house is either determined at the time when both parties sign the rent-to-own agreement or when the lease expires. The house’s price can be based on either the current value of the house or some expected future value. Locking in the purchase price of the home makes it more predictable of whether or not the house will be affordable to you. However, this also presents risks to the seller and buyer. If the buyer agrees on a price and the price of houses drops making the future value lower than what they agreed to, the buyer would end up paying more than what the house is actually worth. Likewise, if the seller agrees to sell at a price and house prices rocket in the next few years, the seller would be selling the house for less than it is worth.

Pros & Cons of Rent-to-Own Homes

Before you decide to commit to a rent-to-own agreement, it is important to know the benefits and risks that these arrangements present:

Pros

  • You build equity while you are renting - If what you pay for the option fee and rent credits throughout the years are used to pay for the future down payment of the house, you will have built some equity at the end of your lease agreement.

  • You get to test the house - By living in the house for a few years before purchasing it, you will have the chance to see if there is anything you don’t like about the property or area before fully committing to it.

  • You don’t have to qualify for a mortgage initially - Since you are not expected to buy the house until the end of the lease agreement, you don’t have to qualify for a mortgage. You can use this time to build your credit score and save some money for a down payment to help increase your chance of getting approved for a mortgage or getting a better mortgage rate.

  • Purchase price - If you are able to lock in a reasonable future purchase price and house prices are on the rise, you might benefit by paying less than what the house is worth in the future.

  • No competition if you choose to buy - Since you have the option to purchase the house, you won’t have to compete with other buyers who are also interested in the same house.

Cons

  • You will pay more monthly - Since some of your rent will go towards rent credits, you will be paying a larger amount than usual every month. Instead of doing this, and risk losing your rent credits if you don’t purchase the house or if you break the terms of the lease, you could simply rent a place and put some money aside every month.

  • Extra fees - You will have to pay an upfront option fee, which is typically nonrefundable if you do not purchase the house. On top of that, you might be responsible for maintaining and repairing the house while renting it.

  • Falling house prices - If the house prices fall in the future and you have already locked in a purchase price, you might end up paying more for a house that is at the time you purchase it, worth less than before.

  • Lose money if you don’t purchase - In a few years, your personal circumstances can change so that you are no longer interested in buying this house. While you are free to walk away from the deal, you will be losing a lot of money, including the upfront option fee, rent credits, and any repairs that you have made to the house.

  • Little control - Since the landlord is still the legal owner of the house until you purchase it, they are responsible for making any mortgage payments, paying property taxes, etc. If your landlord fails to make mortgage payments, they might lose the house through foreclosure, in which case the bank ends up getting the house. The foreclosure process doesn’t immediately end your lease, but it might mean that your purchase agreement is no longer enforceable.

What To Do Before Signing A Rent-to-Own Contract?

Find an experienced real estate attorney - Rent-to-own contracts can be confusing and hard to understand, so getting an experienced real estate attorney who can explain the terms of the contract to you can be very useful. Since they have dealt with this type of contract before, they will know what to look out for and can make you aware of important details in the contract, such as in what cases you can lose your option to buy the property.

Choose the right rent-to-own agreement - Between the two types of contracts: lease-option and lease-purchase, lease-option gives the tenant a lot more flexibility down the road. Although, investing in a house that you might not ultimately buy seems like a waste of money, being obligated to buy a house that you no longer want or can’t afford is a much bigger problem.

Understand the contract - To have a clear idea of what you are getting yourself into, you need to know exactly what you are agreeing upon. Before signing a rent-to-own contract, look at the following issues and make sure you are on board with:

IssuePoints of concern
Option Fee & Rent Credits
  • The amount to be paid
  • In what cases are they nonrefundable
  • Whether it will count towards the down payment or not
Deadlines
  • When is the option fee to be paid
  • When is rent to be paid
  • When should you give notice of your intent of buying
Home purchase price
  • How is it determined
  • When will it be determined
Your responsibilities
  • Are you responsible for maintaining the house
  • What does “maintaining” include
  • Are you responsible for repairing the house

Get a home appraisal - If you are planning to lock in the purchase price of the house, make sure you get a home appraisal first. A home appraisal will tell you how much the home is worth now and help you determine if the price offered by the seller is reasonable.

Get a home inspection - While you will probably be able to determine the issues with the house while renting it, it is smarter to simply get a home inspection before signing the contract. If you are responsible for maintaining and repairing the house during your tenancy, a home inspection can save you a lot of money by letting you know of these future issues prior to you signing a contract. Moreover, depending on the results of the home inspection, you might not even be interested in buying that house at all.

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