Homeownership has always been a dream for many Americans, as it symbolizes financial stability and monetary success. If you, too, are looking for a way to finally buy a house, advertisements like “No credit, No problem” must often sit in your head time-to-time.
How about “No cosigner and down payment required!”? Chances are you have heard this one as well. The truth is, these claims used as bait are usually flat-out lies, or they come with a hidden secret that is bound to surprise you.
Rent-to-own means that you are renting the home, and a portion of the rent is going towards your down-payment. It is a clear path to homeownership when done correctly and can be a viable way to purchase a home. However, there are some pitfalls that you will want to be aware of before starting the process.
The Home Buying Dilemma
Buying a house can be difficult if you do not have good credit, money for a downpayment, inevitable repairs, and unexpected costs that show up randomly. In this case, being able to own homes is straight up not an option for you.
How about renting a house? It may also not be a good idea because house renting doesn’t add to your equity build-up or offer any shiny rays of a new house. In conclusion, you can’t buy a house due to financial conditions, and renting doesn’t seem profitable in the long run.
What is it that you can do now? A rent-to-own agreement is your most viable option!
When buying your own house, a plausible option for most people is a rent-to-own home (RTO). This practice has been used by many young people and families who may not have the credit and other factors in their favor to secure a home loan.
We’ll be going in-depth about rent-to-own homes, how it works, is it a good idea, types of RTOs, comparison between buying houses and RTO, advantages, disadvantages, and much more.
Without any further ado, let’s begin.
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What is a Rent-To-Own Home?
A rent-to-own home is a special agreement between a homeowner and renter that allows the occupant to buy the house they’re renting after a predetermined number of years at a certain sales price.
In a rent-to-own agreement, you’ll be paying your monthly rent payments to the property owner exactly like you pay rent to a landlord. However, a segment of those monthly payments will go towards your down payment (that you can use to buy the house) at the end of the lease. The monthly rent in an RTO contract is usually a bit more than the average housing market rent.
In addition to this, you will also be paying an option upfront fee of 2% – 7% of the house’s value, giving you the option to buy the house eventually. But, if you do not buy the house at the end of the RTO contract, you’ll lose your extra payments as well as your down payment.
How Does Rent-To-Own Work?
A rent-to-own agreement is where you rent a house and progress towards making a home purchase. Every month, a chunk of your monthly rent will go towards an eventual down payment for the home, and you’ll have the right to buy the property at the end of your agreement. A rent-to-own contract usually lasts for one to six years. The terms can be flexible depending on your personal situation.
The best part about rent-to-own agreements is—flexibility. Everything is negotiable in an RTO agreement; both the house owner and tenant agree to certain predetermined contract terms, and all those terms can be changed to satisfy everyone’s needs.
However, there are two types of rent-to-own agreements that you can choose while thinking about a home purchase:
Lease-option agreement
In this case, the renter has the ‘option’ to purchase the house at the end of the contract. They aren’t obliged to buy the property and can walk away if they do not prefer the home purchase.
However, you’ll lose the extra payments that you made into the house if you decide not to purchase the property. The longer you stay in a lease-option agreement, the more you’ll lose if you decide to walk away.
Lease-purchase agreement
In this case, the renter is legally obliged to buy the property when the lease-purchase agreement ends. Make sure you review everything, do a home inspection, and know what you’re getting into.
If you’re sure about your decision, work with a real estate agent or an attorney who can professionally due diligence the contract for you. However, you will have to compensate them for their advice.
In both the agreements, the buyer and property owner determine a purchase price for the house. By the end of the agreement, the buyer has the option or is obliged to purchase the home for its predetermined price.
If the house goes up in value faster than expected, things work out in the buyer’s favor as they enjoy the built-up equity they get when purchasing the house. If the house loses its value, the tenant can back out of the agreement (only if it’s a lease-option agreement).
Typically, buyers apply for a traditional mortgage loan when the time comes to purchase the property. Depending on lending programs, when you are ready to purchase your home, the lenders may also treat the transaction as a refinance.
Many lenders treat a Lease Option or a Lease Purchase as a refinance because you have a vested interest in the property. The equity you have gained in the property by paying additional payments and increasing property values can make it much easier to finalize your contract.
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Lease-Option Vs. Lease-Purchase
Whether you should go with a lease-option agreement or a lease-purchase agreement, the answer depends on the real estate market.
In times where home prices are constantly going up, locking down a lease-purchase agreement will help you build more and more equity in your home by the end of your lease.
On the other hand, if the home prices are stagnant or even depreciating, you may prefer to go with the lease-option agreement so that you have the option to back off in case the price for the house drops dead.
If you do not intend to buy the property, both types of RTO agreements can make you lose money and alter with the dream of owning a house.
Conditions of a Rent-To-Own Agreement
Every rent-to-own home contract is unique and predetermined according to the needs and wants of the tenant and property owner. There are no standard or fixed terms in an RTO contract.
Typically, a rent-to-own agreement includes a predetermined rental amount, the option or obligation to purchase the house, a specific lease term, the percentage of monthly rent that goes towards the down payment, and an outline that specifies the maintenance responsibilities divided between the property owner and the renter.
Here are some common conditions and terms to look out for:
Purchase Price
The most important term of a rent-to-own contract is the purchase price of the property. The agreement must specify when, how much, and on what basis the home’s purchase price is determined.
In some cases, the tenant and property owner will agree on a purchase price when the contract is signed. The purchase price is most often higher than the current market value.
In other cases, the tenant and property owner will determine the purchase price at the end of the lease based on the property’s fair market value. This can be a risky move. In most cases, it is best to agree on a price upfront.
Rental Agreement
A rent-to-own agreement also includes rental terms since the house owner still possesses the property title until the tenant exercises their option to purchase the house.
You’ll be paying monthly rent payments throughout the entire contract term, along with an option fee upfront if you choose to go with a lease-option contract. A percentage of your monthly payments will go to the down payment and applied to the eventual purchase price.
For instance, if you pay $1,500 in rent every month for six years, and 20% of that is credited towards the purchase, you’ll have $21,600 rent credit in the end.
Maintenance
Depending on the terms of your lease-option agreement, the responsibilities of property maintenance may abide by only the renter or both the renter and property owner.
Since the property owner is ultimately responsible for expenses like property taxes, homeowner association fees, and insurance, most contracts include terms that leave the tenant in charge of basic maintenance requirements. These include cleaning, landscaping, damage repair, and even appliance repair.
You must understand that managing the property (mowing the lawn or cleaning the gutters) is a lot different from replacing a damaged roof or fixing the house’s electricity.
We suggest you take advice and help from a real estate agent or attorney to be sure about what you’re getting into.
Penalties
In order to ensure that you get all your extra payments by the end of the lease, you must follow the terms of the agreement. If you do not pay your monthly rent on or before the due date or do not abide by the set terms, you can void the agreement and lose your extra payments.
Make sure you avoid late payments or any other disruption within the rules.
Why is the Rent-To-Own Agreement your best option?
Compared with a mortgage loan, a rent-to-own contract is a financially better way to buy a house if you have a low credit score or an unattractive credit report. It can mean the difference in paying thousands of extra dollars in interest or not even getting a loan at all.
Getting into a rent-to-own agreement can be very beneficial when you expect to be financially stronger within a few years.
Some of the benefits include:
- Buy a home with a bad credit score: If poor credit has been stopping you from qualifying for a traditional mortgage loan, a rent-to-own agreement can offer you the time to improve your credit report and eventually get a mortgage to buy the home you’re renting.
- Experience with the home and neighborhood: If you’re living in the house with a lease-option agreement, you’re not obligated to buy the property by the end of the lease. This simply means that you can freely test drive the house before you start calling it home.
You can learn a lot about the house in a RTO contract, including hidden property damages, nosy neighbors, many other severe issues regarding the property, and also if the house feels like home.
- Lock in the purchase price: If you’re sceptical about the increase or decrease in home prices, a rent-to-own agreement can offer you the option to lock in the purchase price.
Buyers can get the seller to agree to lock the purchase price at the current market value even when the purchase will take place several years in the future. In addition, buyers have the right to back out if the home prices fall in a lease-option agreement.
However, if the price fall difference is less than the downpayment you’ve gathered by the end, it’ll not be profitable to let the property go.
- Minimum cash requirement: Rather than accumulating a big amount of money for a downpayment, which is usually 20% of the home’s purchase price and is paid to the mortgage lender, the buyer pays a one-time option upfront fee which is only 2% to 7% of the purchase price and is paid to the property owner.
- No qualification (rent-to-own property with bad credit): Mortgage programs and mortgage rates are often too difficult to catch up, for people with bad credit.
A mortgage lender has strict guidelines, such as a good credit score, significant downpayment, a <36% debt-to-income ratio, and employment longevity, making it difficult to make a home purchase with little money and bad credit history.
On the other hand, you will be accepted at the sole choice of the property owner/seller in a rent-to-own contract.
- Avoid paying private mortgage insurance (PMI):
Private mortgage insurance (PMI) is a particular type of insurance that you’re required to pay if you have a conventional loan. It is paid by the borrower of the conventional mortgage and protects the lender against loss if a borrower defaults. The amount you may have to pay can add up to thousands of dollars over that time.
Private mortgage insurance is usually paid when you make a downpayment of less than 20% of the home price while taking a conventional loan. However, a rent-to-own agreement offers you the time to save for your down payment, which allows the chance to skip PMI altogether.
- Leverage: You’re spending very little money to take control of one of the most expensive and profitable assets—a house.
These are some amazing benefits that take part in the complete rent-to-own agreement. You can enjoy them along with the satisfaction of knowing you are likely to own the house one day.
When Rent-To-Own Does Not Work
Even with the benefits, you must know when a rent-to-own agreement does not work. Rent-to-own contracts may not be beneficial in every case and for everyone, which is why here are a few situations it may not be wise to choose a rent-to-own lease:
- Inability to secure the loan
If you aren’t sure you’ll be getting the loan at the end of the agreement, you must continue renting rather than getting into a rent-to-own contract.
Derogatory marks like foreclosures, repossessions, and bankruptcy on your credit report can keep you from qualifying for a mortgage loan.
- No certain plans to improve your credit score
A rent-to-own agreement may give you the time to improve your credit, but it doesn’t give you a plan to do so.
If you have no idea about where to start improving your credit score, you can refer to our mini-guide that will take you through every important aspect of building credit.
Start with getting an annual credit report from all the three major credit bureaus. Then, create a well-established plan to increase your credit score and improve your credit report before you sign a rent-to-own property contract.
- Unable to deal with higher fees and monthly rates
Paying rent to live under a roof every month is a lot different than paying rent in a lease-option contract.
According to the Federal Trade Commission, these contracts often come with higher monthly rent payments and an option fee that you need to pay upfront. However, these extra fees and payments ultimately help you by the end of the lease.
- You pay rent on a later date
If you’re someone with a tight budget, and it often happens that you submit late payments, you must steer clear from an agreement that can make you lose money.
Take Precautions
Many rent-to-own agreements specify that the renter must pay monthly rent on time, or they’ll lose the rent credit. So, if you’re someone who often makes late payments, wait for a few months to save up money for rent (that can last for a few months or help you in months you’re financially depleted) before you sign on a rent-to-own property.
If any of the conditions above are true in your case, you must wait for some time before getting into a rent-to-own contract.
Signing the rent-to-own contract
If you have made the decision to get into a rent-to-own agreement, here are some things to consider:
Determine the right terms—If you aren’t 100% sure about buying the property, choosing a lease-option agreement instead of a lease-purchase agreement is a good option.
Seek professional help—Buying a property is a significantly big deal, as it is one of the most expensive assets one can own. Hiring a qualified real estate agent who can explain the contract and help you understand what you’re getting into is essential.
Research the home—Before you sign the contract, organize a home inspection, order an independent appraisal, ensure that all the property taxes are up-to-date and there are no hidden damages on the property.
Bottom Line
A rent-to-own agreement offers you the opportunity to move into a house right away, along with the time to improve your credit report & save up for a downpayment before you apply for a mortgage.
It is essential for you to understand the terms and conditions of such an agreement and consult a qualified real estate attorney who can clarify the pointers and important deals of the contract as well as your rights before you sign anything.
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