How Does Rent To Own Work?

If you are renting, you are just throwing your money away. No doubt you have heard this oversimplification many places. Of course, a decision about whether to rent or buy a home is rarely that black and white: Either can make sense depending on your situation.

What if there was a way to combine the pros of both? Some say a rent-to-own deal is that happy medium. When you rent to own, part of your rent goes toward purchasing the home you are renting at some later date. So instead of evaporating into thin air, your rent is actually laying a foundation for your future literally.

Sounds great, but as with any major financial decision, there are pros and cons to rent-to-own deals. We will discuss the basics of rent to own, its benefits and drawbacks, and a few alternatives below so you can make an informed decision on whether it is right for you.

Rent-to-Own 101: How Does It Work?

The process starts, of course, with a contract. Actually, in this case, it starts with two: a rental agreement and an option to purchase. Here is what you need to know about both:

Rental Agreement

Your rental agreement will look much like a standard lease. It will specify your rent (more on this in a minute) and the term in most cases, it will be two or three years.

There will be several standard terms and conditions you will need to meet: For instance, no structural renovations in the house, general conduct requirements. Violate these terms, and just like any tenant, you can be kicked out. However, this time, you also risk losing any money you have paid toward the home is eventual purchase.

One big thing that may be different in this lease agreement: You, the tenant, will be responsible for maintenance costs and general upkeep of the home instead of the landlord. The logic here is that you will be motivated to keep the house in top shape if it will be yours in a few years.

Lease Option

The lease option gives you the rights to purchase the home you are renting, typically valid for a term equal to the lease term set forth in your rental agreement. So if the rental agreement specified a one-year lease term, the lease option will usually give you one year to buy the house without worrying about anyone else swooping in and snatching it out from under you.

To maintain first dibs, you will pay an option fee. The amount can vary widely: According to Zillow, anywhere from 2-7 percent of the home’s purchase price is typical. This option fee is then credited toward the home’s purchase at the end of your term. However, if you decide not to buy, you will lose the money.

How Much Does Rent-to-Own Cost Me?

First, let’s talk about rent. A certain percentage of your rent will usually go toward the purchase price of the home. This is something you can, and should, negotiate with your landlord. One thing to keep in mind when you negotiate: Because of this credit, you will likely be paying more to rent the home than you otherwise would. For instance, a house that would normally go for $1,000 a month might go for $1,250, with the extra $250 saved as credit toward the home’s purchase. So if you seek a higher credit, your rent may rise accordingly. Also note that your lease will probably specify that if you are late paying rent, you will lose that month’s rent credit.

Next, let’s talk about the home’s purchase price. In most deals, you will agree to a purchase price upfront, typically current market value or a bit higher. In limited other instances, you may delay that decision until your lease term is up. Whether one or the other will be more beneficial hinges on whether the home value rises or falls during that time. A key point in either scenario, however, is that the purchase price is also negotiable just like you are buying a house the traditional way.

Let’s look at an example. You enter a two-year rent-to-own agreement for a townhome. The option fee is 3% of the home’s $200,000 purchase price, or $6,000. This is due up front. Your monthly rent is $1,600, and 20% ($320) goes toward the purchase of the home every month. (Your landlord will probably put it in an escrow account during your lease.)

At the end of your two-year lease term, assuming you exercise your option to purchase, the fixed $200,000 purchase price will be discounted by a) the amount of the option fee and b) the total rent credits. So subtracting the $6,000 option fee brings the price down to $194,000. Then, subtracting $7,680 in rent credits ($320 x 24 months) further reduces it to $186,320.

And remember: If you decide not to purchase the house, the option fee and credits are nonrefundable.

Who Benefits Most From Rent-to-Own Agreements? Who Should Pass?

For the right buyer and seller, a rent-to-own deal can be a win-win. But on both sides, as with any major financial decision, there are pros and cons you will want to note.

Pros for buyers

Rent-to-own can be worth looking into for would-be buyers who simply can’t wrangle a mortgage the traditional way. Typically, that’s because you either lack enough cash for a down payment or your credit score isn’t strong enough to be approved for a mortgage (or both). With a rent-to-own agreement, you get more time to boost your credit and save up, all while getting a head start on building some equity.

You may also benefit from a rent-to-own agreement if you are reasonably sure you want to stay in the house and neighborhood long-term, but still want to try it out while maintaining an escape route (albeit a pricey one). If you can lock in a purchase price before the home’s value rises, you may be able to save in the long run, too.

Pros for sellers

Of course, there are some benefits for the sellers, too: They get a long-term tenant who has a big stake in taking care of the property, and the nonrefundable option fee helps reduce some of their risk if the buyer eventually walks.

They can often still get a high sales price and rent for the home, even in a shaky market, because the tenant/buyer gets to start building equity from the get-go. They also won’t have to pay the pricey real estate commission (usually 3%-6% of the purchase price) they would if they sold their home the traditional way.

Cons for buyers

While a lease option gives you first dibs to purchase the home you are renting, it doesn’t guarantee that you will be approved for a mortgage at that time. If you are unable to boost your credit or save enough for a down payment during your lease, you could still be shut out and you will lose all the money you paid toward the purchase, too. To help protect against this scenario, experts recommend meeting with a mortgage lender before signing the deal to know exactly what you will need to qualify at the end of the lease.

When you lock in a purchase price up front, you also risk watching the home’s value drop during your lease. If that happens, you could be stuck paying an inflated price for the home simply so you don’t lose your option fee and rent credits. Be sure to research home prices and do a home inspection before signing these things will help you be more confident that the home is actually worth the price.

Finally, you should be wary of a rent-to-own agreement if you are not absolutely sure you can be a model tenant during your term. Paying your rent late means you will probably forfeit that month’s credit, and violating any of the lease terms could get you kicked out of the home minus, of course, your option fee and any rent credits you’ve paid.

Cons for sellers

The biggest con of rent-to-own for a seller is that if a willing buyer showed up on your doorstep offering full price (or more) for your home, you would have to refuse your tenant’s lease option gives them that right exclusively during the contract term. If you lock in a purchase price initially (the most likely scenario), you may leave money on the table over a traditional sale if your home’s value climbs dramatically.

Source: thesimpledollar.com