How Rent-to-Own Works
Putting a down payment on a house is by far the most expensive part of the home-buying process. For example, in the United States, the average down payment on a $250,000 house is around $12,500 (5% of the purchase price), and many people shoot to pay 20% to avoid higher fees going forward.
New homebuyers that don’t have enough money saved up for a down payment might want to check out a rent-to-own program, wherein your monthly rent payments are applied toward the future purchase price of your home.
This post covers the basics of how the rent-to-own process works, what to expect, and why it’s risky.
What is Rent-to-Own?
A rent-to-own agreement — also known as a lease option — is a type of contract where the buyer agrees to rent a property for a certain period of time before obtaining ownership.
In some cases, the rent-to-own process can last for a few months. Or, it can stretch on for several years. During that time, the renter gains equity in the home.
There are two types of rent-to-own agreements.
1. Lease to purchase agreement
A lease-purchase agreement enables a tenant-buyer to lease the property for a certain term and obligates each party to a rental-purchase agreement when the lease term ends.
In other words, when you sign a lease to purchase agreement, you agree to buy the house and are expected to fulfill your end of the deal. In most cases, it’s very difficult to back out of a lease-to-purchase agreement and get your money back.
2. Lease option agreement
In a lease option agreement, the tenant gains the option to purchase the property at the end of the rental period, which usually stretches about three to five years or longer.
This purchase option provides a bit more flexibility for the buyer. For example, you may lease a property and then determine that you do not want to own it after all once you are a few months or years into the process. With a lease option agreement, you can have an out if needed.
The Rent-to-Own Process
Next, let’s go over each major step in a successful rent-to-own transaction.
- Form an agreement with a landlord
- Determine who covers fees
- Figure out how rent is applied
- Pay a non-refundable fee
- Complete the lease term
- Secure financing
1. Form an agreement with a landlord
The rent-to-own process is usually much less extensive than a traditional homebuying process.
It typically involves a sit-down between a landlord and a tenant or prospective buyer, where the two sides agree on the sales price of the home — including when and how the price is set.
For example, the home’s market value may be determined at the time the rent-to-own contract is signed, allowing the buyer to lock in a set price. Or, the home price may be set when the lease reaches its expiration date.
During the arrangement, the two parties also determine whether it is a lease to purchase or lease option agreement.
2. Determine who covers fees
The two parties need to determine who is responsible for covering fees during the renting process.
For example, a property may come with several recurring expenses like repairs, homeowners association fees, taxes, and maintenance.
It’s critical to outline in writing who is responsible for these fees. Oftentimes, sellers try to avoid paying expenses, passing them along to the homebuyer instead. But these fees are almost always negotiable.
As a buyer, don’t automatically assume that it’s your responsibility to pay for something like property taxes, heating repairs, or even utilities.
3. Figure out how rent is applied
In a rent-to-own agreement, the renter/buyer agrees to pay rent throughout the term of the contract. However, you must discuss with the seller whether or not the rental payment goes toward the purchase price.
For example, you may agree to pay $1,500 in rent for a period of five years, with 20% — or $300 — going toward your purchase price each month. At the end of the term agreement, you would have $18,000 in rent credits to apply to the purchase price.
It’s very important to get this in writing before signing a rent-to-own agreement. Even if you know or trust the landlord, you need to make sure that a fixed portion of your rent is in fact going toward the purchase price.
4. Pay a non-refundable fee
Once you agree to the terms of the contract, you are expected to pay a one-time non-refundable fee to the seller, securing your stake in the home. This fee is usually a percentage of the purchase price of the home. Be sure to check whether the fee goes toward your equity.
5. Complete the lease term
The next step is to move forward with the lease. During this time, you typically live in the house and pay monthly payments toward rent, with the rent payments hopefully going toward building equity in the house.
It’s very important to remember during this time that the homebuying process is not over. You should be saving every penny so that you can cover future costs in the next leg of your homebuying journey — the closing process, which occurs at the end of the lease.
6. Secure financing
Back to my comment about saving every penny. You should also be prepared to face additional closing costs, such as real estate attorney fees, real estate agent fees, home inspection fees, and any other expense that might come up.
As a general rule of thumb, it’s a good idea to have at least 5% of the purchase price saved up to cover closing costs.
Key Considerations When Executing a Rent-to-Own Agreement
Don’t let bad credit history influence your decision
Oftentimes, homeowners will seek rent-to-own arrangements because they lack the credit to get a loan from the bank. The hope is that during the lease agreement, the buyer can rebuild their credit score and qualify for a home loan from the bank.
With that in mind, you still have to be careful about biting off more than you can chew. For example, the costs of renting a home, supporting a family, and saving up money for a down payment and closing costs can add up much quicker than you might think.
If you sign an agreement that you cannot honor, this could lead to further credit issues, making it even harder to get a loan down the line.
If you have bad credit or are struggling to pay your bills on time, you need to get to the root of the problem and fix the underlying cause — like poor budgeting or a limited cash flow — before trying to buy your own property.
You’ll pay more in the long run
Paying a down payment over a few years may seem like a great idea because you won’t have to save up a massive lump sum. However, buyers typically wind up spending far more than they have to when doing this type of lease.
Most people are going to get a better deal by saving up a sizable down payment and buying a home in the traditional way.
Your situation could change
Keep in mind that a lot can happen throughout a lengthy rent-to-own agreement. For example, you could get a job in a new area or start a family and wind up needing a bigger space.
Three to five years is a long time for a young homeowner. Oftentimes, young families start looking for larger properties after three to five years in a starter home.
In a rent-to-own agreement, by the time the agreement is up, you may already outgrow the property. Of course, this depends on the specific space, your job, and family size, among other factors.
The home value could plummet
Real estate markets fluctuate, so there is a chance that your home’s value goes down during a multi-year rent-to-own contract. If you lock in a purchase price upfront, there’s a risk of paying more than it’s worth when the contract expires.
As such, it’s a good idea to get an independent appraisal before signing a rental agreement with a landlord. Also, be wary of someone who is very eager to sell.
Hire a lawyer to review your contract
Whenever you make a real estate transaction, it pays to hire an experienced attorney who can review the terms. This attorney can serve as your advocate and help you look out for potential issues.
If hiring an attorney is financially out of the question, you might want to save up some more money before trying to buy a place.
Frequently Asked Questions
Is a rent-to-own risky?
Yes and no. Rent-to-own can be risky for some homebuyers, especially those who lock in a rate at the beginning of a contract and sign a binding purchase agreement.
The primary risks include higher costs, fluctuating home values, and the potential for your personal situation to change during the rent-to-own process.
However, it can also be a great option for potential homebuyers who don’t yet have enough money for an initial down payment.
Is renting to own a good idea?
Only you can determine that. It may be a good decision if you are having trouble getting a mortgage loan, and you really want to move into a certain place for an extended period of time.
On the other hand, if you are able to save up money for a down payment, or might want to move in a few years, you should probably not take this path.
What is a lease option agreement?
A lease option is a type of contract that gives renters the ability to purchase a rent-to-own home when the rental period expires. It’s different from a lease-to-purchase agreement, which is a binding contract for the sale of a home.
The Bottom Line
The bottom line is that rent-to-own is a backdoor method of buying a property. It could be useful if you’re having trouble getting a home the traditional way. But financial shortcuts aren’t always beneficial in the long run.
If you’re having trouble securing a loan, try and figure out why you can’t get one and focus on fixing the problem. The truth is that the home-buying process is expensive because it’s designed to weed out people who can’t afford the massive responsibility.
If you bypass this process, you could wind up getting into trouble with the many costs that come with homeownership.
Whichever course you decide to take, make sure to hire a qualified attorney and real estate expert to guide you through the process.