Rent-to-own arrangements pave the way to home ownership for those who may not qualify for traditional financing.
Under a rent-to-own agreement, buyers get to live in their dream home while paying for the right to purchase that home at the end of their lease. Further, buying a home with this arrangement gives buyers time to improve their credit, save for a down payment and experience home ownership before making a full commitment to purchasing.
How does rent to own work?
Unlike a traditional home purchase, where the buyer obtains a mortgage to purchase a property, a rent to own agreement combines a rental agreement with the option to buy the house at the end of the lease term. The rental contract is a legal document commonly referred to as a lease option or a lease-to-own agreement. With this arrangement, the buyer leases the property for a set amount of time. Once the lease expires, the buyer may purchase the property.
During the lease term, a percentage of the rental payment goes towards the purchase price of the home. The buyer also pays a one-time, non-refundable fee called option money or option consideration. The amount of the fee varies and is usually a percentage price of the home. The option money gets credited to the purchase price at closing, and gives the buyer first pick on purchasing the house at the end of the lease term.
What is important to note, is that unlike a security deposit in a lease agreement, the option money and rent credits are non-refundable. A buyer who opts not to purchase the home at the end of the term forfeits all money paid towards buying the house. Buyers who are considering a lease-to-own agreement should pay particular attention to the wording in the contract.
The contract should state that it is a lease-to-purchase agreement “with the option” to purchase. The option gives the buyer the right to purchase the home but does not obligate them to do so. A contract that does not state “with option” may legally require the buyer to purchase the property at the end of the lease term.
Rent-To-Own Contracts Explained
The lease-to-own contract can be complicated, as it outlines three critical details that can make or break the success of the transaction. Each portion of the contract describes responsibilities for both the buyer and the seller.
Terms of the Lease
As with any lease, the rental agreement specifies the start and end date of the contract. The agreement also outlines the amount of the monthly rent, fees for late payments, and forms of payment accepted. The seller may also specify rules regarding pets, smoking and subletting rules. Lastly, the lease terms specify who is responsible for repairs and upkeep on the property. Often, with a lease-to-own agreement, the buyer is responsible for all maintenance.
Terms of the Option
The option portion of the contract discusses what rights the seller has at the end of the lease term. While the most common agreement is that the buyer may purchase the property, this portion of the contract may also describe what, if any, options the buyer has to back out of the transaction. There may be fees and penalties associated with this option, and the contract should specify the exact amount. Further, the agreement stipulates how much option money the buyer must pay, as well as whether or not that amount is refundable. It is essential to keep in mind that a lease-to-own agreement may also have rules regarding eviction and forfeiture should the buyer fail to make payment.
Terms of the Purchase
The seller and buyer agree on the terms of the purchase upfront, specifically the purchase price. From a buyer’s perspective, the purchase price should reflect fair market value for the house given appreciation during the lease term. If the ultimate purchase price ends up being higher than the appraised value at the end of the lease term, the lender may not extend financing to the buyer. The seller, on the other hand, will not want to lose money on the transaction and may wish to negotiate a purchase price that is up to 10% higher than the current market value of the home. Ultimately, the buyer and seller must agree on a fixed amount and spell it out in the contract.
Good Candidates for Renting to Own
Renting to own is a good option for buyers who may not qualify for traditional bank financing. Buyers with less than ideal credit will find that leasing with the option to purchase is their best option for home ownership. Buyers in this situation use the lease term to work on improving their credit and save for a down payment.
Things to Know Before Signing the Contract
Buyers should treat a lease-to-own contract just like a home purchase transaction. As such, the buyer should perform all due-diligence such as completing a home inspection and obtaining an appraisal. The home inspection gives the buyer a clear picture on the condition of the home. A buyer should use the inspection report to negotiate repairs and to negotiate a fair purchase price. The due-diligence period is also great time for buyers to consult with a lender to determine the requirements to qualify for the home. Knowing the requirements upfront will help buyers learn what they need to work on during the lease term to meet those requirements.
Next, buyers should make sure that the title is free and clear of all other claims so that there are no disputes over the title at the end of the lease term. Lastly, before signing the contract, buyers should verify that the mortgage payments and tax payments are current and that the home insurance has been paid. The last thing any buyer wants to encounter is the home going into foreclosure before the end of the lease. In addition, buyer and seller should agree on who is responsible for paying taxes and insurance during the lease agreement.
Pros vs. Cons of Renting to Own
Buyers who need a little time to work on their credit can still get into their dream home with an option to purchase once their credit situation improves. Renting to own is also an excellent opportunity for buyers to try things out in a home before committing to the purchase. When it comes to locking in the price, buyers in a market where home prices are on the rise, a lease-to-own option gives those buyers a chance to get into a home before being priced out of the market. Conversely, buyers who do not improve their credit situation at the end of the lease term may not qualify for a loan, and ultimately lose all monies invested in the property. In addition, down payments for lease-to-own agreements can be substantial. Backing out of the deal could wipe away their chance at home ownership as well as money that could be spent on another home.
Buyers who take advantage of a lease-to-own arrangement get a chance at home ownership despite their current credit or financial situation. Lease-to-own contracts can be a wonderful opportunity to rebuild credit and save for a down payment for purchasing the home at the end of the lease term. Not only that, depending on the market, they are a great way to lock in the price on a home before housing prices rise.