Rent-to-own real estate purchases can be appealing, but there’s also the potential for some real dangers to buyers in these agreements. For some, rent-to-own is a fantastic opportunity to invest in a future home purchase, but for others, that same decision could be financially damaging. That’s why it’s important to weigh all the pros and cons before committing to a rent-to-own home.
We talked with Maureen Connolly, an agent with 17 years of experience in New York, and Brad Korb, a top-ranked agent in Burbank, California, in order to uncover all the advantages and disadvantages of a rent-to-own real estate purchase. With the help of their professional advice, you can assess your personal risks and determine if rent-to-own is in your best interest.
What is rent-to-own?
Renting with the purpose of owning your own home comes in two flavors.
A rent-to-own deal, also known as a lease option agreement, allows buyers the opportunity to purchase a home after a specified amount of time while in the meantime living at the property as a tenant.
A lease purchase agreement requires the renter to buy the home when the lease is up; lease purchase agreements come with a lot more catches than lease option agreements, and buyers should approach lease purchase agreements with caution. For the purposes of these pros and cons, we’re going to be looking exclusively at lease option agreements.
Rent-to-own contracts can be negotiated to fit the needs of both the buyer and the seller, but a typical contract should include:
A premium payment
This is also known as an option fee or option consideration and is a non-refundable, upfront payment which locks in the price of the home and ensures that the tenant has the first option (not obligation) to purchase the home on or before the agreed-upon date.
A typical premium payment is between 2.5% and 7% of the agreed-upon purchase price.
A term (or time limit)
Contracts can stipulate any amount of time, but the typical range is between one and three years.
A purchase price
The contract will set a fixed purchase price of the home. This number might be a little higher than current market value because the seller needs some kind of motivation to wait several years to sell rather than selling now.
A rent credit
This is the amount of your rent that gets credited toward the final sale. For instance, if your monthly rent payments are $1,400 for two years and your rent credit is $200, you’ll have $4,800 already paid toward the purchase price at the end of the term.
Often, the monthly payments are higher than the average rental market to account for the credit. Note that rent credit is usually also non-refundable.
A renewal stipulation
The rent-to-own contract needs to define whether or not the renter/buyer has the option to extend the terms of the contract, if needed, and for how long.
A maintenance clause
Whose responsibility is it if the bathroom light goes out? What about the bathroom plumbing? Some buyers and sellers set a dollar limit — such as, the buyer will fix anything under $500, and the seller will pay for anything over that amount. But local laws govern these details to varying degrees, so contracts can look different.
Tips for would-be rent-to-owners
Connolly says that rent-to-own contracts should be taken on a case-by-case basis, and a good agreement needs to work for both the buyer and the seller. If you’re considering a rent-to-own scenario, be sure to:
- Consult a real estate lawyer: A professional will be able to go over the contract with you to help translate terms and watch for details that may not be in your favor as a buyer.
- Get a home inspection: Korb tells buyers to consider a rent-to-own contract “like a long escrow,” meaning it’s important to enter the contract in the same way as you would any other home purchase contract. That’s why you should insist upon a full home inspection. You don’t want to find major problems after you’ve invested money via premium and rent credit payments, especially since the seller is not obligated to fix them.
- Talk to your lender: Go over the situation and get their professional opinion about whether this contract is in your best financial interest. Ask about the likelihood of obtaining the mortgage loan you’ll need at the end of the rental period.
- Get seller’s disclosures: This, too, is a normal part of a home purchase, and your agent can help with this portion. Similarly, look into any insurance claims and make sure the title is clean.
Rent-to-own: The pros
Gain peace of mind
With rent-to-own, you can find the neighborhood of your dreams and get your foot in the door. It’s an opportunity to lock in your ideal living situation before you may otherwise be able to. Plus, you don’t have to worry about the price of homes skyrocketing past what you can afford.
Important if: you intend to stay in the area for a long time and are worried about price growth outpacing your ability to buy.
Don’t worry about credit
Many landlords and rent-to-own sellers accept lower standards of credit than mortgage companies. Landlords tend to look in the 600 to 620 range. Lenders tend to look in the 620 to 660 range at minimum, but better rates are given to those with better credit numbers. (The exception would be FHA loans, which can be obtained with credit scores in the 500 range.)
Important if: your credit took a recent hit, but you’re in a position to rebuild it in a few years’ time.
Build purchasing equity
The rent credit portion of the deal helps you save money towards the eventual purchase price of the home. Note that this is not the same as traditional equity because you are not yet the homeowner. As far as purchasing equity, you can think of it as investing in your future rather than investing in a home.
Important if: you tend to spend money that’s in the bank. Rent credit is money saved that cannot be touched.
Lock in your purchase price
As previously mentioned, a rent-to-own contract should spell out the final, agreed-upon purchase price of the home. Though it may be a little higher than current market value, in a rising market, that locked-in price could work to your advantage later when it’s time to finalize the deal.
Important if: you anticipate a rise in housing prices in your neighborhood.
Eliminate buyer’s remorse
Rent-to-own could be considered a “try it before you buy it” scenario. Not sure if you’ll like a split-level layout? Wondering if you’ll be able to keep up with pool maintenance? Questions like these don’t need to be answered right away with a rent-to-own contract.
There should be no obligation to purchase (double-check that you’re signing a lease option and not a lease purchase agreement!) so if you end up not liking the home (or finding issues you don’t want to deal with), you haven’t invested as much.
Important if: you’re unsure about homeownership or if you’re the type of person who tends to second guess major purchases. If this is you, be sure that your premium payment is on the low end, just in case you do end up changing your mind.
Get a good monthly mortgage payment
Connolly says that a rent-to-own situation may be “Perfect for someone who may not have enough for a 20% down payment.” The minimum down payment to get a conventional loan is 3% of the purchase price, and the more you put down at closing, the lower your monthly payments will be.
At the low end of the premium payment scale, you’ll invest 2.5% in your rent-to-own property from the very beginning. Add the rent credits into that sum, and you should be in good shape to get a loan with a decent monthly payment rate. In fact, in some cases, you may end up paying less each month toward your mortgage than you did when you were renting.
Important if: you want to lower your monthly housing payments in the future and you prefer a method of saving that cannot be touched (remember that purchasing equity).
With a rent-to-own situation, you don’t have to wait to move into your dream house. You also don’t have to pack up and move again when your lease term is up. You can get into the place you really want and start making it your home.
Important if: you know this is the house you want to be in, long-term.
Rent-to-own: The cons
You could lose money
It’s worth pointing out again — premium payment and rent credits are non-refundable. That means if you back out of the deal (which is your right), or if something goes wrong (see the next point), you’ve lost your initial investment for good.
Important if – you have hesitations about the longevity of this deal.
Yes, even with an airtight contract, there are still things that could go wrong. The house could be foreclosed on, or the landlord could get a lien on the property, for example.
When you have a rent-to-own agreement, those might be problems you inherit or they could be problems that nullify your deal.
Important if: you don’t have a buffer for unexpected expenses.
You may have to take on repairs
You could be responsible for repairs while you’re renting. This might be fine if you’ve got room in your budget and want to invest in your future home anyway (maybe you’d rather be the one to pick out new kitchen hardware when a couple of drawer pulls break). But you’ll definitely want to check your contract to make sure the maintenance clause suits your needs and abilities.
Important if: you don’t have an already established maintenance budget. If this is you, be sure to put one in place before you sign a lease option agreement.
The purchase price is locked in
Yes, we mentioned this in the “pros” section too. That’s because that locked-in price could really go either way. If the market goes up, the fixed purchase price is to your advantage, but if the market goes down, you’re tied to a price that’s not sustainable.
A too-high purchase price means you likely won’t get your loan, since the property won’t meet the appraisal criteria of the lender.
Important if: you anticipate the housing market going down in your neighborhood. If you’re unsure, consult with a top real estate agent to determine trends.
There is no financing guarantee
If you can’t qualify for a loan when the term is up, you might be out of luck. This means that your credit score and your debt-to-income ratio need to be in good shape by the time you intend to buy, or else you may lose your premium (especially if your rent-to-own contract does not have a renewal stipulation).
Important if: you lack job security or have a good deal of other (non-housing) debt.
Late payments are a big deal
Unless otherwise specified, the seller has the right to terminate the rent-to-own agreement based on late payments. That’s right — one late payment could derail the whole deal, and you could lose your investment.
Important if: you do not have a late fee clause built into your contract.
Scams are abundant
Unfortunately, there are those who would wish to take advantage of rent-to-own buyers. Beware of contract language that indicates any kind of obligation to purchase (remember, it should be an option, not an obligation).
Also, don’t provide any personal financial information upfront. If a seller refuses to let you have an inspection done, it’s time to walk away. Likewise, if they cannot provide a contract (fee-free) for you to take to your attorney, that should be a major red flag.
Important if: you don’t do your homework!
So, is rent-to-own the best plan for you? By weighing these pros and cons, you can determine the best course of action when it comes to rent-to-own properties. And with the help of a top-performing real estate agent and a real estate attorney, you can make an educated decision that works in your favor.
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