You’ve heard the ads on the radio, or seen billboards promising that you can become a homeowner without a big down payment. How? Through a rent-to-own program. While these programs might sound too good to be true, if you’re interested in a rent-to-own home, you’ve learned that they are a legitimate way for homeowners with poorer credit or a smaller down payment to buy.
Sounds great to you — but what about from the seller’s perspective? How does rent to own work for a seller, and why would they sell their house this way?
Why would a seller want to rent-to-own a house?
Understanding a seller’s motives can help you figure out whether this particular rent-to-own deal is for you. Sellers can have many reasons for entering into a rent-to-own agreement rather than selling outright.
The market could dictate a rent-to-own sale
The market could be the reason a seller might want to rent-to-own a house. Matthew Le Baron saw this when he was an agent from 2008 through 2011 in the Boise area. “If an owner was underwater and couldn’t sell,” he says, “They rented the home out and gave people the option to purchase. You’ll see more rent-to-own properties in more of a down market, more of a buyer’s market.” For whatever reasons a seller might want or need to move, a rent-to-own deal makes it possible.
Financing options could lead to a rent-to-own sale
If it’s tough for buyers to get financing right now, the seller might have trouble finding someone to buy the house. It’s possible that buyers in the area are experiencing credit issues, or perhaps they don’t have a down payment together. In those circumstances, the seller might choose to do a rent-to-own.
In Le Baron’s opinion, “People that are going down this path have limited credit or a limited down payment but still want to technically own their home.” If a seller lives in a city going through an economic downturn, which has led to less-qualified buyers — but the seller still needs to move — a rent-to-own helps both them and a buyer.
House or property issues
In other cases, the house or the property is the issue. Kelly Springer, a partner at the firm Willenbring, Dahl, Wocken, & Zimmermann, has handled many contract-for-deed transactions. She says that the most common reason she sees sellers choosing to rent-to-own is for “farm real estate or family transfers. Farms, as a business, run in the red a lot. With new underwriting requirements, post the last recession, the bank can’t finance it.”
An unusual property that has no true comparables in the neighborhood or a residence that’s also a business could prevent a buyer from obtaining financing. If you’re confident that the farm or business would show a profit in a few years and you could buy it outright then, a rent-to-own might make sense.
An older home
Maybe the seller knows that their home can’t compete with other homes in the area on the open market. If those homes have been updated, but still aren’t selling quickly, the seller might worry that listing their home without upgrades would be pointless. An elderly seller might not want to make repairs if they’re retiring and downsizing; another seller might not have the money.
While you might think you’d get a deal for a home that hasn’t been updated and is a rent-to-own, that isn’t always the case. If you have poor credit, you represent a greater risk to the seller; if you miss your monthly rent payments, they could struggle to pay the mortgage. Even if the home isn’t in as good a condition as others in the area, you could still pay the same price for it.
This is a scenario where a rent-to-own sale works for the seller, but buyers should still perform their due diligence on the property. Springer says that one of the biggest mistakes she sees rent-to-own buyers make is that they’re “not thinking about some of the things you’d normally do as a buyer of normal real estate; they’re not thinking about title work or inspection.” But if you get all the way to financing the house, and there’s an issue with the title, you could lose your deposit. Treat buying a rent-to-own property just like a normal sale and have all inspections and title work done.
Paying too much for a property in the rent-to-own agreement could lead to an inability to finance it in two years. As the buyer, you’re betting on price appreciation, but Le Baron has seen instances where a buyer agreed to a purchase price of $100,000, the market dropped during the rent-to-own period, and the buyer couldn’t get an appraisal for $100,000 when it came time to get a mortgage and buy the house.
Seller wants regular income
Some sellers would prefer to establish a steady stream of monthly income for a time. A retiree could view a monthly revenue stream in the form of rent as a more attractive option than a lump sum payment. For tax reasons, collecting a balloon sum later could help them save money or better plan for their retirement.
How does rent to own work for a seller?
Sellers still have to find a buyer and agree on terms. While they’ll likely have to pay legal fees, they could avoid a real estate agent’s commission if it’s a transaction between family members. Typically, the final contract needs to address the home’s final price, monthly payments, and what will happen during the contract’s term.
Types of rent-to-own agreements
There are two common forms of a rent-to-own agreement; a lease option or a lease-purchase agreement.
A lease option combines a traditional rental lease with the option to purchase the home later. Your option fee could be 1% to 2% of the home’s eventual purchase price. It only locks in the price, and you’ll likely have to pay a down payment on top of the option fee.
Under a lease-purchase agreement, a portion of your rent typically goes toward the down payment. Because of this, you may pay higher than market rent. When a lease-purchase agreement ends, you must buy the property.
Lease options usually work better for buyers because they’re not obligated to buy the property at the end of the contract’s term. If, after living in the house, you’ve decided that you don’t like the neighbors, the price is too high, or the crime rate has gone up, you can walk away.
Pricing a rent-to-own home
When the buyer and seller decide on a price, will it remain static for the contract’s term, or will it increase 5% to 10% to adjust for price growth? There is risk either way; if the price doesn’t increase, the seller could end up losing money if the home gains a lot in value, if it does increase, the buyer could be locked into paying too much for the house.
Buyers with poor credit should not expect to get a bargain on a rent-to-own. Your lower credit score represents a higher risk to the seller. The price and fees they charge you will reflect a desire to hedge their risk.
Option fees and rent-to-own
How much will the seller charge for the option fee? Similar to a down payment, the option fee gives you the right to purchase the house at the contract’s end for the agreed-upon price. This money isn’t refundable, and if you default on the contract’s terms, the owner can keep it.
Payments on rent-to-own contracts
In addition to deciding on a rent payment, your agreement should specify to whom you should pay your rent. “If the owner misses a monthly payment, the property could be foreclosed upon even if the buyer has been making their payments,” warns Le Baron. He typically advises buyers to “make payments to a long-term escrow company” to protect their investment and ensure that the home’s mortgage remains current.
When discussing the rent payment, the seller may want to include a rent premium. A rent premium is the amount you pay above market rent. As a buyer, you want to know if the premium is applied to your down payment. This could be an easy way for you to save up the down payment to finance the home into your own name, particularly if you struggle to maintain regular savings habits.
Insurance, taxes, and repairs
Clarify if the payment wraps in insurance and taxes, or if you’ll be responsible for those, too. If the seller’s lender requires that they put these funds in escrow, your only worry is that they stay current on their mortgage.
If the roof leaks or a pipe breaks, who’s responsible for having it fixed? Since the owner isn’t a true landlord, they could decide that the buyer must take care of all maintenance and repairs. This represents a risk to you, the buyer. If you’re unable to buy the house outright at the contract’s end, any money you spent on repairs or improvements has benefited only the seller.
Late payments on a rent-to-own
Lastly, what happens if the tenant is late on a payment? While a grace period for late payments is rare, if she’s negotiating on behalf of the buyer, Springer tries to get the owner to accept one. She also advises buyers to “try to wrap in a dispute resolution or notice before the owner starts cancellation.”
If a grace period isn’t stipulated in your rent-to-own contract, then a late payment can void the contract entirely, so don’t ignore this clause.
How long does a rent-to-own contract last?
A two-year agreement is standard for a rent-to-own contract. The idea is that, at the contract’s end date, the buyer will have fixed their credit or saved up a high enough down payment enough to qualify for a mortgage, or the house will have gone up enough in value to appraise.
If you can, try to get a contract extension built into the agreement. Perhaps you can add six months to a year onto the term if you pay an additional option fee, preserving your original investment if you’re still unable to get a loan. From the seller’s perspective, they have little to lose if they agree to this clause, but it provides you some additional protection.
Is rent-to-own right for you?
If you don’t have a full down payment, or you’re still repairing your credit score, renting-to-own your residence could be a great way to ease your way into homeownership. You won’t feel like you’re wasting money on rent, and you could fix things up and make it your own.
Be honest with yourself about whether you’ll improve your credit score by the time the balloon payment comes due. If you have doubts, talk to a real estate expert and get professional advice. You are entering into a contract that has financial and legal ramifications — but one which could eventually help you achieve your dream of homeownership.
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