Rent-to-Own Homes: How the Process Works

While traditional mortgages are a common path to homeownership, you do have alternatives. Rent-to-own agreements are an option for people who may not be able to secure a mortgage initially or make an upfront down payment. Instead, they enter into an agreement with a property owner to purchase the home at the end of a lease term.

Understanding Rent-to-Own Agreements

If you do not have the funds to cover the down payment on a house, the goal of home ownership can feel out of reach. Rent-to-own agreements can give people a way to save for a down payment while living in a home they will eventually buy.

Under this type of agreement, the seller gives you the option to buy the property after a certain amount of time. In the meantime, some of the money you pay rent will be put aside to help you cover your eventual down payment.

Components of Rent-to-Own Contracts

Rent-to-own contracts will vary depending on the situation, but they typically have two main components:

• The lease agreement: When you initially move into the home, you are doing so as a renter. As part of the contract, you agree to lease the property and pay the owner rent. A portion of your monthly rent may be put aside in an escrow account, which will later help you cover your down payment.
• The purchase agreement: The second component of a rent-to-own contract addresses the option or obligation to purchase the home after a period of time agreed upon by the renter and property owner.

Types of Rent-to-Own Contracts

If you decide to enter into a rent-to-own contract, you have a couple of options to consider.

Lease-Option Contracts

If you choose a lease-option contract, you can choose whether to buy the house at the end of the agreed upon period. If you decide the house is not right for you, you are not obligated to buy.

It is important to note that this type of contract will likely include stipulations for maintaining your option to buy. For example, you might lose the option if you make late payments.

Lease-Purchase Contracts

When you sign a lease-purchase contract, you are agreeing to buy the home at the end of the lease period. If you do not buy the home because you change your mind or cannot afford it, you could face legal liability.

Financial Aspects of Rent-to-Own Agreements

Before signing a rent-to-own agreement, it is important to consider the various financial elements of the contract.

Option Fee and Rent Payments

Rent-to-own contracts often include an option fee, a set price that you pay to secure your option to buy. This non-refundable fee varies. You could expect a typical fee to be 2% to 7% of the property's value.

During the period that you live in the home prior to purchase, you will be responsible for paying the owner rent. Keep in mind that the rental price may be higher because a portion of that monthly payment is being set aside to cover your future down payment.

You may be able to apply your non-refundable option fee to the the purchase price of the home, depending on the details of the agreement.

Determining the Purchase Price

You and the seller will have to agree to a purchase price. Typically, this number is agreed upon when you initially enter the agreement. In this case, change in the home's value over time does not impact the purchase price.

Some agreements stipulate that the price will be negotiated and set once the lease period is up.

You will be able to use any money set aside from your rent payments to cover your down payment. You will likely need to apply for a mortgage to cover the remaining cost.

Responsibilities and Maintenance

A rent-own-agreement is different than a typical lease. Be sure to understand what you are responsible for and what the landlord is responsible for before signing a contract.

Tenant vs. Landlord Responsibilities

In a standard lease agreement, the landlord is responsible for all maintenance and repairs of the property. This may be the case in a rent-to-own agreement. In other cases, the person living in the home and planning to buy the property accepts responsibility for maintenance and repairs.

Insurance and Additional Costs

During the lease period, you will not own the home. You will need renters insurance instead of homeowners insurance to ensure your belongings are adequately covered. Once you purchase the home, then you will need a homeowners policy.

Tenants and landlords will also have to come to an agreement regarding who shoulders the responsibility for property taxes, utilities, and any homeowners association (HOA) fees.

Advantages and Disadvantages

Understanding the pros and cons of rent-to-own agreements can help you decide if they are right fit for you.

Pros of Rent-to-Own

• Building equity: Under this type of agreement, part of your monthly rent payment can go toward equity in the home you plan to own.
• Time to improve your credit: Rent-to-own agreements could be attractive to people who do not have strong credit scores. During the lease period, you can work on improving your credit to prepare for eventually securing a mortgage.
  
• A guaranteed purchase: The housing market can be very competitive. If you have a rent-to-own agreement, you will not have to worry about bidding wars with other prospective buyers.
• Less moving: When it comes time to buy your home, you won't have to deal with the cost and logistics of moving. You will already be settled.

Cons and Risks

• Potential financial loss: If you change your mind or you are unable to purchase the home when the time comes, you could be out a significant amount of money. At minimum, you will lose your option fee. If you signed a lease-purchase contract, you could face more financial fallout.
• Possibility of overpaying: It is hard to predict how the value of a home can change, especially over longer periods of time. If you agree upon the price of the home upfront, it is possible you will end up paying more than it is worth at the time of sale.
• Contractual obligations: You might be responsible for paying for repairs and maintenance on the property before you actually own it.
• Fewer choices: Rent-to-own homes are not the most common option on the market. You may need to do a little more digging to find an option that works for you.

Who Should Consider Rent-to-Own?

A rent-to-own agreement can be a good option for people who cannot purchase a home immediately. It is important to consider your financial situation and market conditions.

Ideal Candidates

Rent-to-own agreements can be a good path to homeownership for people who do not have the money for a down payment upfront. You can save for that big, lump sum while you pay rent and live in a home you want to buy.

These agreements can also be a good fit for people who need time to improve their credit in order to qualify for a mortgage.

Market Considerations

Housing market conditions can influence how attractive this type of contract is. Consider the length of the agreement and potential changes in the market. If you lock-in a price at the beginning of the agreement, you risk overpaying in the future.

Due Diligence and Legal Considerations

Always do your homework before signing a rent-to-own agreement.

Contract Review and Legal Advice

It is a good idea to work with a real estate attorney before signing a rent-to-own agreement. An attorney can help you understand your responsibilities and evaluate the agreement's alignment with local real estate and tax regulations. Additionally, an attorney will ensure the agreement is clear on how your funds are being held for your eventual down payment.

Property and Seller Evaluation

You will want to make sure you are comfortable with the property and the seller before signing the contract.

While you won't own the home immediately, you should still take precautions. Work with the seller to schedule a home inspection. You want a clear picture of any potential issues the property has before you agree to buying it in the future.

You will want assurance that the seller is trustworthy and financially stable. Are the property taxes paid? Is the home properly insured? Talk to your real estate attorney about the kinds of questions to ask when vetting a potential seller in a rent-to-own deal.

Additionally, be aware of potential rent-to-own scams. The Federal Trade Commission (FTC) warns of potential scams such as sellers who do not actually own the property or properties with unpaid taxes.

The Bottom Line

A rent-to-own agreement can get you started on the journey to home ownership if you are unable to afford a down payment right now. It can also be a good way to get started if you need time to repair your credit before applying for a mortgage.

Before signing an agreement, it is important to understand your obligations under the contract and any potential risks. A real estate attorney can help you review any contract before you move forward with signing.