What is rent-to-own?
Updated March 9, 2022
Home buyers in search of an alternative path to homeownership may consider a rent-to-own agreement. This type of real estate arrangement is ideal for parties who do not have enough cash for a down payment, who can’t get a mortgage or whose credit score is not high enough to buy a home. These potential buyers can therefore lock in a desirable home in the near future using a rent-to-own agreement.
Rent-to-own agreements allow prospective home buyers to rent a property for a specified and agreed upon amount of time while maintaining the option to purchase the home once the lease expires. The agreement includes a standard lease as well as the purchase option.
Rent-to-own offers a "try before you buy" option for home ownership. But you need to make sure you know all the details of the deal before you sign on the dotted line. Credit: Maria Ziegler/Unsplash
Any parties can create a rent-to-own agreement; however, they are often used as part of programs designed to revitalize a neighborhood or to provide more affordable purchasing options in expensive neighborhoods.
There are two types of contracts used in rent-to-buy agreements. The first is a lease-option contract where the renter has the option to choose to purchase the home once the lease expires. If the renter chooses not to purchase the property at the end of the lease, the option expires without any penalty to the renters who are not obligated to purchase or continue renting.
The second is the lease-purchase contract where the renter is required to buy the property once the lease expires. This is enforced whether the buyer has the financial backing to purchase the property or not at the time of the end of the lease, which can be problematic for the renters.
In either type of rent-to-buy contract, renters are usually required to pay their landlord an option fee upon signing the agreement at the rental stage. This fee can also be referred to as option money or option consideration, and it is always a one-time, upfront fee. The fee amount is often negotiable as there isn’t a set rate, although it is often within the range of 1% to 5% of the property’s purchase price.
Some contracts allow buyers to put all or part of the option fee toward the purchase price at the end of the lease. This helps the renter begin to build equity in the property. If the buyer is unable to afford to purchase the property at the end of the lease or chooses not to pursue the option to buy, they forfeit any upfront fees paid upon the contract signing.
Why You Might Consider It: Rental Credit and Try Before You Buy
There are a few aspects of rent-to-buy agreements that make them attractive to potential buyers and property owners:
- Some contracts allocate a percentage of the rent paid to the owners to be put toward the purchase price of the property. This is referred to as a rent credit. It is common in rent-to-buy agreements that allow for a rent credit to set rental prices higher than local market rates to account for the benefit of this credit.
- A rent-to-buy agreement also allows the buyer to test drive a property before buying it.
Prospective buyers should treat the rental property under a rent-to-buy agreement as if they were already purchasing the home. They should get the home inspected and order an appraisal before signing the contract. They should make sure property taxes are up to date and that there are no liens on the property. It is also worth looking into the seller’s credit report to see how much equity they have in the property, how long they’ve owned it for and if they’ve run into any financial trouble.
Renters should purchase rental insurance whether they plan to buy the property or not to cover any liability or damage to personal property during the course of the lease.
In some rent-to-buy contracts, the renter is required to pay for repairs and to maintain the property. These details should be clearly covered in the lease, which should include everything from who is responsible for cleaning gutters to who has to pay for roof repairs in order to avoid potential disagreements between landlord and renter. Typically, the responsibility for major home repairs still falls to the landlord as they are on the hook to pay homeowners’ association (HOA) fees and taxes for the property.
The purchase price of the home in rent-to-own agreements can be negotiated between the renter and the landlord when the contract is signed. If the market value of the home increases during the duration of the lease, the buyer is able to get a really good deal as the seller is held to the original, negotiated price. Oftentimes, the agreed-upon purchase price is set higher than the current market value for the property in consideration of the likely increase in market value. If the market drops over the course of the lease, however, the buyer still has to purchase the house at the agreed-upon price.
The seller can benefit from rent-to-buy agreements because they are provided with the opportunity to earn income before selling if they are not in a rush to offload the property. This agreement is also beneficial if they are having trouble finding a buyer initially. It can also protect them against future drops in the market: Sellers can earn a higher price for the home if market prices end up falling over the term of the lease. Also, renters—whether they opt to buy the home or not—are more invested in the property and more likely to take good care of it.
Check the Fine Print
It is important for buyers to carefully check the fine print of any rent-to-buy contract as the conditions—all of which are negotiable—may include such details as late rental payments can result in the loss of the option to purchase. Another downside to rent-to-buy agreements for buyers is that they have less control over the property while leasing and they have to endure a slower process of achieving homeownership.
Sellers stand to risk losing money if home prices rise higher than the agreed about purchase price in the contract. Also, if the buyer chooses not to purchase the home at the end of the lease, the seller may lose more money than if they had just sold the property at the time of the lease agreement because their property is now worth less.