You checked your credit report and the results were… grim. The dream of homeownership seems impossible, but you refuse to give up.
There are other options out there to help you achieve your goal. You’ve heard of rent-to-own homes, but don’t really know much about how they work. Does a rent-to-own home build credit? The answer isn’t as straightforward as it might seem.
This article will walk you through the possibilities offered by a rent-to-own agreement, as well as provide data and professional insights, to help you decide for yourself whether it’s for you.
An overview of rent-to-own
A rent-to-own agreement involves renting a home for a set period of time with the ultimate end goal of buying the home from the owner/seller. On top of the rent, you often pay an extra fee that is sometimes applied to the purchase price of the house as a down payment when the time comes for you to buy it.
After the predetermined amount of time has passed, you have the option to buy the home. Rent-to-own agreements use two different types of lease agreements: lease-option and lease-purchase. The agreements are similar, but differ on a key point.
A lease-option contract gives you the option to buy the house once the lease expires. If you decide against buying the house, the option expires, and you can walk away free of any obligation. If you’re going to do rent-to-own, this is the lease you want.
However, be aware that you’ll lose any investment you paid into the house. The seller will keep any money paid on top of the monthly rent that was intended for a down payment on the house.
So, the longer you stay in a rent-to-own, the more money you’ll lose if you choose to walk away.
Watch out for these types of contracts. In a lease-purchase agreement, you are required to buy the house at the end of the lease.
“Be sure to review everything and know what you’re getting into,” advises Norris Bishop, a top-selling real estate agent in Georgia with more than 17 years of experience. He suggests working with an agent who can review the contract for you.
“I’ve heard of and seen contracts that weren’t fair to the would-be buyer. Without a professional to check over the contract, you could end up signing an agreement that has an overly strict clause. For example, you might overlook a clause where, if you were late on your monthly payment once, you forfeit your deposit.”
Before you sign your rent-to-own agreement, you’ll need to determine when the purchase price of the home is to be decided. In many cases, you’ll want the purchase price locked in before signing the contract. This is especially true in a real estate market where the home might appreciate at a higher value in a couple of years.
Low mortgage rates can help a little to offset rising house prices, but mortgage rates can fluctuate on a weekly basis.
All of that means that if you’re shopping for a rent-to-own home right now, you’ll probably want to opt to lock in the purchase price as soon as you can.
The other option is to add a contract clause where the price won’t be decided upon until the lease expires. You’ll pay the home’s market value at that point.
Either way, it’s a good idea to get the home appraised to ensure you have an appropriate estimate of the home’s value and make it easier on yourself to get approved for a mortgage when the time comes.
“You need an independent, third-party opinion on the worth of a home,” says Dave Smith, owner of AppraisalSmith of Kansas City. He’s been certified and working as an appraiser for over 15 years. “Having an appraisal done safeguards people from overpaying on a house.”
Smith states that some homes appraise for below the estimated value. In fact, around 10% of all homes appraise below the expected home price. He notes that when a home under-appraises, it isn’t always bad, at least for the would-be buyer. It gives you the chance to renegotiate the contract and can save you money if the seller agrees to lower the purchase price.
Once the price is set and you’ve signed your rent-to-own agreement, you generally must pay the seller a nonrefundable, upfront fee. This fee is often referred to as an option fee.
The option fee is what gives you the right to buy the house once the lease ends in one to five years. The amount you pay typically ranges between 2.5% and 7% of the home’s purchase price. A favorable contract will apply some or all of your option fee to the purchase price when the lease ends and you’re ready to buy.
As the name implies, you’ll obviously pay monthly rent to live in the house. However, every contract differs in terms of how much extra you must pay each month, as well as what percentage of that payment goes toward your home purchase.
You’ll want clear terms laid out in the contract showing where the option payment is going. It’s possible for a seller to have you pay an additional $200 each month and only apply $100 of it to your home purchase.
Ideally, you’ll negotiate a contract where most of the extra money you’re paying on top of rent goes into an escrow fund toward buying the house. Once the lease ends, you’ll then be able to secure a mortgage and buy the house.
If you decide to walk away from the agreement, you’ll unfortunately lose both your option fee and the monthly fee you were paying. This can add up to a monumental loss depending on how long you stayed at the house.
What’s the credit advantage of going the rent-to-own path?
Simply put, a rent-to-own home gives you the time you need to build up your credit score.
The higher your credit score is, the better deal you’ll be able to secure on the mortgage loan. Lenders give people with excellent credit scores far better interest rates, which translates to you paying less over the life of the loan.
As a rule you should aim to have a credit score of at least 620. The better your credit score is, the more options you’ll have for the types of loans you can get.
So how do rent-to-own homes build credit?
There are two different ways a rent-to-own agreement helps build your credit before you apply for a mortgage.
First, ask that your rent is reported to the major credit bureaus.
Bishop suggests you add a clause in the contract that requires the owner to report your payments to the credit bureaus.
“Always pay with a check as well. That way, there’s a clear trail and it can be documented.”
The second step involves doing everything in your power to improve your credit score.
Consider establishing multiple lines of credit. If you can, take out a loan or diversify the types of loans you have. For example, if you already have credit cards, look into a car loan if your monthly budget will allow one.
If you have any high-interest debt, you’ll want to focus on paying it down. Having too much debt can affect your chances of qualifying for a loan.
Throughout the course of your rent-to-own agreement, you should strive to build up a savings account. This savings account should be to help cover the closing costs you’ll have to eventually pay.
Most importantly, pay all of your bills on time every month. A single late payment can drop your credit by as much as 90 to 110 points. That’s a steep hole to climb out of!
If you do everything correctly, by the end of your lease agreement, your credit score should be in stellar shape.
The verdict: Does rent-to-own help your credit?
A rent-to-own home doesn’t directly build your credit. It’s the steps you take throughout the term of the lease that will help to boost your credit score.
Bishop says to “stay diligent.” As long as you’re receiving credit for your monthly rent payments, you’re building capital. You have far more stability with a rent-to-own home than with regular renting.
Keep a close eye on your credit score, get credit lines, and pay your bills on time and you’ll get your foot in the door of homeownership by the time the lease ends. If you’ve done what you should throughout the lease, your credit score will be in such excellent shape that you’ll get far better rates on your mortgage interest rate than you would’ve beforehand.
Last, hire an attorney or work with a top real estate agent so that you have a professional who can look over the contract and watch out for your best interests.
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