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In competitive housing markets, renters seeking to cross the threshold into homeownership might pursue less traditional paths. A rent-to-own is one of those venues. Since it sounds like a simple hybrid of renting and buying, it's easy to oversimplify the transaction. But there are a lot of variables that can gray the topic and make the question, should I rent-to-own? a difficult one to answer. It largely comes down to the type of housing market in which a potential buyer or renter is seeking to make a home purchase.
With that in mind, let's dissect the topic and get more familiar with the rent-to-own concept.
Defining a Rent-to-Own
What exactly is a rent-to-own (also called lease-to-own)?
Rent-to-own homes are homes that include a clause in the rental agreement which either gives you the option to buy or an obligation to buy after a certain time period. You make rent payments each month and a portion of those payments can count toward your down payment. Should you decide to buy, the excess money can be applied to the home purchase. -Jean Folger, Investopedia
Terms to Know
- A contract for deed. A contract for deed is a sale agreement between the buyer and seller without the involvement of a third party like a bank. Instead, the buyer assumes ownership of the home and pays directly to the seller, who maintains possession of the title until the home is paid for.
- Lease option agreement. Also known as a lease with the option to purchase, a lease option agreement allows the renter to either walk away or buy the home at the end of the lease and prevents the owner from selling to anyone else before the tenant exercises their right to choose.
- Lease purchase agreement. A lease purchase agreement sets a time frame for the renter to purchase the property. Typically, the price is determined beforehand, but in some cases, the parties set a future price, meaning that on a specific date they’ll bring in a third party to determine the home's value and set the price.
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Why Choose a Rent-to-Own?
A rent-to-own is appealing for some because it provides financial flexibility. Obtaining a home loan, putting in an offer, coordinating a home inspection, and closing is the traditional way to buy a house. But for those with less than perfect credit, a new job without proof of income, and sometimes those who are self-employed, leasing to ownership allows the purchaser to lock in the house and buy time to qualify for the mortgage — even better if the homeowner is willing to agree to a contract for deed and you can avoid formality altogether!
For the seller, the why is easy:
- Attract a higher-caliber tenant.
- Receive a larger amount of money upfront.
- See larger profit margins should the renter choose not to buy.
The Process of Renting to Ownership
So what does this whole transaction look like? Here’s an overview of the process:
Non-refundable option payment. Essentially, the renter provides the seller with a sum of money to reserve the right or option to buy the property during or at the end of the lease. The number can fluctuate, but it typically falls anywhere between 1% and 5% of the purchase price. This also keeps the homeowners from putting the house on the market and attracting more buyers.
The lease. As with any lease, the variables will fluctuate. The things you want to focus on are duration (because that dictates how much time you’ll have to accrue a down payment and increase your credit score to apply for a home loan) and the terms lease option and lease purchase.
Here’s why. The lease option allows you to walk away at the end of your lease. If you decide that the property is not the right fit and need to move on, you can cut your losses and turn the other way. However, if your lease says lease purchase, there’s no option. At the end of your lease, you are legally obligated to buy the property.
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Purchase price. The biggest question of all is, what is the purchase price? Most of the time, this is determined when the contract is signed, but sometimes it’s at the end of the lease.
There are pros and cons to both approaches.
- Negotiating at the beginning of your lease can help you lock in a great rate if the market is continuing to increase. However, there’s a potential that the property’s value will go down and you’ll end up overpaying for the home.
- Determining a purchase price at the end of your lease will help you settle on the most accurate fair market value for the property. However, the former option’s pro is this one’s con. Should the value of the home increase while you’re leasing it, you’ll wind up paying more than if the price was determined at the start of your lease.
Applying rent to the principle. How much of your rent is going toward the purchase price each month? Take a look at this example from Investopedia:
“If you pay $1,200 in rent each month for three years, and 25% of that is credited toward the purchase, you’ll earn a $10,800 rent credit ($1,200 x 0.25 = $300; $300 x 36 months = $10,800).”
Home maintenance. It all depends on the contract you sign, but more often than not, unlike a traditional rent situation, you’ll be responsible for the maintenance and repairs of the property.
Because home maintenance applies to a variety of things, it’s okay to get into the details with this. Specific duties and requirements should be written in the lease, such as who’s responsible for mowing the lawn, maintaining HOA standards (i.e. exterior paint, gutters, landscaping), and appliance repairs? And don’t forget about bigger ticket items such as roof repair, water damage, plumbing issues, and more.
The end of your lease. When you reach the end of your lease, the type of contract you signed will come into play. If you signed a lease-purchase, then you have no option but to buy the house whether you can afford to or not.
But if you signed the lease-option then you have a choice to make. Do you:
- Follow through with your intent to buy the house? Then, apply the credit you made each month to the purchase price, apply for a home loan, and seal the deal. Or,
- Walk away, leaving the non-refundable option fee and rent credit behind?
Learn about your home financing options: Home Financing Overview for Military Home Buyers.
The Benefits of Renting or Leasing to Own
Here’s what can work well for those who choose to rent-to-own.
There’s more time to build a down payment. Sometimes, the only thing between you and homeownership is the lump sum required by lenders for a down payment. Leasing the home you want to buy before you buy it gives you more time to save the appropriate amount.
Avoid buyer competition later. A lease-to-own cuts out all the competition. By navigating this path to homeownership, you’re able to avoid a bidding war and enjoy a more peaceful transition into your new home.
You have more time to increase your credit score. One of the biggest reasons a homebuyer will choose the rent-to-own route is simply because they have less than perfect credit and can’t obtain an affordable mortgage. This alternative to traditional home buying allows you to not only secure the home you want to buy, but it also gives you more time to build credit.
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The Pitfalls of Rent-to-Own
As you may have guessed, a rent-to-own isn’t always the best decision. While some will see benefits to this method, there are some components that buyers should know.
It can be more expensive and harder to save. You can expect to pay more both upfront and each month with a rent-to-own than you would for a standard rental property. Though some of the increased rates go toward the cost of the home at the end of your lease, there’s a risk of losing it all should you choose to walk away instead of purchasing the property. In the same way, spending more money each month can make it more difficult to save for a down payment and build your credit score.
A less expensive rental allows more flexibility until you’re able to pay off debt, provide proof of income, increase your credit, and qualify for a home loan.
Learn how to put your best financial foot forward: What to Know About Your Finances Before Buying a Home.
The market could change. Most of the time, the purchase price for the property is determined upon signing the lease. While that can provide an incredible opportunity to lock in a great rate at a time when the market is rapidly rising, it can do the opposite. To avoid this pitfall, it’s best to get an appraisal done, look at the city’s plans for development, look at trends in the neighborhood, and do your best to predict what the home will be worth in two, three, or four years from now.
You’re tied to the owner’s finances. Let’s think about the worst-case scenario for a minute. What if you sign a lease-to-own, live in the property for a year, maintain it, and plan to buy it in six months, but the owners fail to make their mortgage payments? The lender could foreclose on the home. Dave Ramsey reminds us, “That house goes to the bank — not to you.”
Now you’re not just a tenant without a home, you’re a tenant without a home and facing a hefty financial loss. He adds:
“Or, if the seller just up and changes their mind after they’ve signed a rent-to-own contract, it would take expensive legal action to enforce the contract in that scenario. That’s a cost you may not be able (or willing) to pay.”
Contract for deeds (good for buyers, bad for sellers). While there isn’t an overwhelming number of concerns for sellers to offer a rent-to-own, Senior Loan Officer at KS State Bank, Jim Wallace warns sellers of Contract for Deeds.
Let’s say that you’re the homeowner and you agree to a Contract for Deed. You hang onto the title but hand over the property. Instead of walking away with the financial value of your house in full, you’re now strung along by monthly payments.
While that might not seem like a big problem in and of itself, it can be. The loan still falls on your credit report which can make it difficult to get a new one when you’re looking to buy your next house. More importantly, the buyer doesn’t follow the formal application process they would when applying for a mortgage. If the renter were to default on payments or fail to follow city code and ordinance, the consequences for their actions fall on you.
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Rent-to-Own Tips for Buyers
What are some things you can do to end up on top? Very simply, do everything you can do now to ensure that it’s a home you want to buy later.
- Treat it like you would if you were buying the home traditionally. When you buy a home, you get to know the area, compare properties to one another, and learn future developments. Even though you’re going into this scenario as a renter, the process should look about the same. Do everything you can to learn if this property is the right one for you and determine fair market value — just as you would if you were applying for a loan and putting in an offer today.
- Read through the lease with a fine-tooth comb. The paperwork can be tricky. It’s best to speak with a realtor/broker and with a lender before pushing forward with the paperwork to save you from potential pitfalls later.
- Get an appraisal. You wouldn't get an appraisal in a traditional rent scenario, but this isn’t a traditional rent scenario. This is a lease-to-buy. So you must establish the value of the property before you begin to negotiate and settle on a purchase price and monthly rate.
- Ask the landlord to consider a contract for deed. A contract for deed is a great option for home buyers looking for more financial freedom. Without a lender involved, you can avoid closing fees, origination fees, and negotiate a lower down payment — as long as you have a landlord willing to work with you.
- Use a third party. Jim Wallace also recommends using a neutral third-party like an escrow service to administer each month’s rental payments. A third-party’s account payment history will help you qualify for a loan should you choose to buy.
Rent-to-Own Tips for Sellers
Sellers often assume more risk going into a rent-to-own than a standard rental property, but there are two main things they can (and should) do to protect themselves:
- Use a third party to vet credit.
- Verify income.
There’s no universal answer as to whether or not a rent-to-own is worth it. It can be a good opportunity for some aspiring homeowners — assuming that you’re certain that it’s a property you want to buy in a few years. However, if you’re unsure if it’s the right choice, it might be best to find another rental to accommodate you and your family while you save money for a down payment or qualify for a loan.
If you’re ready to take the next step of homeownership, take a look at MilitaryByOwner’s many listings and start the search today!
By Danielle Keech
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