Everything You Need To Know About Rent-To-Own Homes
Victoria Araj8-minute read
August 07, 2023
Buying and renting both have advantages and disadvantages.
On one hand, buying a house can be difficult if you don’t have enough money saved for a down payment, closing costs and repairs. On the other hand, renting doesn’t help you build equity – or bring you any closer to becoming a homeowner.
Rent-to-own homes seem to promise the best of renting and buying, but is rent-to-own a good idea? Let’s learn more about rent-to-own homes and how they work.
What Is Rent-To-Own?
A rent-to-own home is a special agreement that allows you to buy a home after renting for a period of time.
With a rent-to-own contract, you pay a bit more in rent than its fair market value. The extra money becomes your down payment at the end of the lease. You may need to pay an “option fee” that equals 2% – 7% of the home’s value to lock in the option of buying the house.
If you don’t buy the property at the end of the lease, you lose your extra payments.
With a rent-to-own property, a buyer may pay an option fee, also called “option money” or “option consideration.” It’s an upfront, nonrefundable fee paid to the seller. While the fee amount is negotiable, it’s usually 2% – 7% of the property's value.
The fee gives the buyer the exclusive right to buy the property later. If the buyer doesn’t buy the property, they don’t get the option fee back. If the buyer decides to purchase the property, the option fee is typically credited toward the final purchase price.
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How Does Rent-To-Own Work?
When you rent-to-own, you rent a property and make progress toward eventually owning it if you buy the home when the lease is up. Every month, a portion of the rent you pay to the homeowner goes toward a down payment on the home. You have the option to use the money that’s accrued to buy the home at the end of your lease term. Keep in mind this credit is limited to the most recent 12 months.
The Pros Of Rent-To-Own Homes
Let’s look at some of the benefits of rent-to-own homes:
- It allows you to save money for a down payment. It’s a great way to pay toward a down payment and test-drive a home to make sure you like it. The percentage of your rent that goes toward the down payment depends on your contract. But again, the monthly lease amount you pay is higher than fair market value, as the extra money goes toward the down payment.
- You can save on repair costs. Most agreements split the responsibility for repairs between the tenant and the landlord. You may agree to cover the costs of small repairs, while your landlord agrees to cover large repairs. This can be beneficial if you want to buy a home but don’t have enough money to cover large repair bills.
- It offers you the option to buy or move. At the end of your lease, you have two options: buy the property or move into another home. If you move forward with the purchase, you’ll get a home loan through a qualified mortgage lender and follow the standard home buying process. The money you accrued for the down payment will go to your lender.
The Cons Of Rent-To-Own Homes
Now that you’ve looked at some pros of renting-to-own, consider some potential drawbacks:
- You may lose money if you choose not to buy. The biggest disadvantage of rent-to-own homes is that if you don’t buy the home, you forfeit any money you paid in rent to the homeowner – plus the option fee if your rent-to-own agreement required one.
- You may not be able to use or receive full rent credit. Rent credit only applies to the previous 12 months, If a buyer rents for a longer period, they will have to negotiate the purchase price to be lowered by the amount paid over the total life of the lease. Additionally, rent credit depends on an appraiser's opinion of the market rent at the time the buyer applies for a mortgage – so if the market rent increased from the time the buyer signed the lease and is now above the monthly rent, then the rent credit cannot be used.
- You may not be able to buy the home if you can’t qualify for a home loan. You also give up your right to purchase the property if you can't get approved for a mortgage loan. In that scenario, the homeowner can rent the home again or sell it. For this reason, it’s crucial to make sure you’re ready to buy the home at the end of your lease and that you can qualify for a home loan.
Types Of Rent-To-Own Contracts
There are two major types of rent-to-own agreements: lease option and lease purchase.
Both contracts allow you to lease a home for 1 – 3 years and then buy it at the end of the term. However, there are some contractual differences between the two agreements that you should know.
Lease Option Agreement
A lease option agreement requires you to pay the homeowner an option fee when you sign. The fee typically costs around 2% – 7% of the home’s value.
The rent money (or rent credits) you save during the lease term go toward your down payment if you buy the home. You’ll negotiate the home’s purchase price with the seller and use an appraisal to determine how much the home is worth. In most cases, your option fee will reduce the property’s purchase price.
You can let the agreement expire if you no longer want to buy the property. But you’ll likely lose your option fee and your rent credits.
Lease Purchase Agreement
A lease purchase agreement works almost the same way as a lease option agreement. You lease a home for a few years, and a certain percentage of your rent is set aside and will be applied toward your down payment to buy the home.
However, when you enter a lease purchase agreement, you’re obligated to buy the home at the end of the lease.
You and the seller agree to a purchase price when you sign the lease. Setting a price beforehand gives you a better idea of how much you’ll need to borrow for a loan. Choosing a lease purchase agreement means you should start shopping for a loan while you’re living in the home or as soon as you agree on a price.
You’ll lose your exclusive claim to the home and all the rent credit you’ve accumulated if you can’t get funding by the end of the lease term. The homeowner can also sue you for breach of contract if you don’t buy the home.
Lease Option Vs. Lease Purchase
Should you choose a lease option or a lease purchase agreement? The answer depends on your financial situation.
A lease option agreement allows you to opt out of buying the home after the lease expires. But a lease purchase agreement requires the buyer and homeowner to commit to a sale at the end of the lease term. However, if the agreed price doesn’t match the market conditions at the time the buyer intends to complete the purchase, the purchase price must be re-negotiated.
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How To Buy A Rent-To-Own House
Here are the steps involved in purchasing a rent-to-own:
1. Agree On A Purchase Price
Negotiate the purchase price before signing the lease agreement. The price is typically determined upfront. The price may be fixed or updated based on market conditions when the agreement expires. If the home’s purchase price is agreed on before the lease term ends, its purchase price may be higher than its current market value to account for the possibility of a future market value increase.
2. Review And Sign The Agreement
Before signing the contract, carefully read the terms and conditions of your lease option or lease purchase agreement. Pay attention to the details, including the length of the rental period, the option fee amount, the monthly rent and any responsibilities related to repairs and maintenance. Knowing this upfront can help save you and the seller headaches later.
3. Pay The Option Fee
You’ll pay the option fee once you sign the contract. The fee is typically 2% – 7% of the home's purchase price.
4. Make Rent Payments
Once you reach an agreement, you start making monthly rent payments. Because your monthly payment often includes an additional amount to allocate to your future down payment, your rent payment will usually be higher than the current market rate.
5. Apply For A Mortgage
Depending on the agreement you signed, at the end of the rental period, you can either apply for a mortgage or walk away from the property. If you decide to buy the home, you’ll begin the traditional mortgage application process to secure financing.
Keep in mind that if you signed a lease purchase agreement, you’d be legally obligated to purchase the home.
When Is Rent-To-Own A Good Idea?
Are you considering choosing a rent-to-own lease? Here are a few situations when rent-to-own is a good idea:
- You need time to improve your credit score. Your credit score influences mortgage loan options like interest rates. A rent-to-own property can give you the time you need to improve your score.
- You need time to save for a down payment. A rent-to-own deal gives you more time to save up a down payment. If you can save enough money in addition to what’s collected in rent credit, you may potentially have enough to make a 20% down payment and avoid private mortgage insurance (PMI).
- You don’t think you can save on your own. Are you living paycheck to paycheck and having trouble saving? Having your monthly rent payments go directly toward a future down payment can help you save because the expense is built into your monthly living expenses.
- You know where you want to live. Rent-to-own leases work best when you know exactly where you want to live. When you sign a rent-to-own lease, you should feel confident you want to live in a particular
When Rent-To-Own Doesn’t Work
Rent-to-own leases aren’t right for everyone and every situation. Here are some situations when you may not want to choose a rent-to-own lease:
- You aren’t sure you can get a loan. You may want to continue renting if you aren’t sure you can get approved for a loan at the end of your lease. Bankruptcies, foreclosures and repossessions on your credit report can all get your mortgage application denied.
- You don’t have a plan to raise your credit score. If a low credit score is stopping you from getting a mortgage, a rent-to-own lease can give you more time to raise your score. But you won’t benefit from the extra time a rent-to-own agreement offers if you don’t plan on working to improve your credit score.
- You’re frequently late on rent. Many rent-to-own leases stipulate that you’ll lose your monthly rent credit if your rent payment is ever late, even by a day or two. To avoid late payments, consider saving a few months’ rent before you sign a rent-to-own lease. And if you feel unsure about your ability to make on-time rent payments, you may encounter the same issue with your monthly mortgage payments.
- You aren’t sure where you want to live. If you aren’t confident that you like the home or enjoy the neighborhood or surrounding community, signing a rent-to-own lease doesn’t offer a benefit.
The Bottom Line
If your savings or a less-than-ideal credit score is holding you back from becoming a homeowner, rent-to-own leases can help potential home buyers progress toward finally owning a home.
Given the risks and downsides of this approach, your best plan of action will be to have a purchase plan in place before you sign a rent-to-own lease, minimizing the risk of wasting your time and the seller's time and potentially losing money.
Ready to take the final steps in your home buying journey? Apply for a mortgage online with Rocket Mortgage® and seamlessly transition from renter to homeowner.
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