For aspiring homeowners who have a poor credit score or lack the money for a down payment, renting to own may be a good alternative to an outright purchase. At the same time, an owner who wishes to sell their home in a difficult market may have better luck with a rent-to-own contract, also known as a rent-to-own agreement, a lease with option to buy, or a lease purchase agreement.
Whether you are a seller or a buyer, you may be wondering how a rent-to-own agreement works, how to create one, and the advantages and disadvantages for owners and buyers. Let’s start with what renting to own actually is.
How does renting to own work?
Renting to own is an arrangement between a homeowner and an aspiring buyer whereby the buyer acts as a tenant, living in the home and paying monthly rent for a specified period. The buyer pays a fee upfront in exchange for the right to buy the home for a predetermined price at the end of the lease, and the owner sets aside a portion of their monthly rent for the down payment (this is known as a rent credit).
There are two types of agreements:
- A rent-to-own contract, or a lease purchase, may refer to a contract where the buyer is legally obligated to purchase the property at the end of the lease.
- A lease with option to purchase, or a lease option, gives the buyer the right to buy the property at the end of their lease term. In other words, the buyer is not contractually obligated to purchase the home.
The terms rent to own and option to purchase are sometimes used interchangeably, so regardless of what you call it, both the seller and the buyer should be clear about the nature of the contract before signing it. In particular, the buyer should be aware of the terms and conditions so they do not mistakenly agree to buy the home when the lease ends.
How to create a rent-to-own contract
A lease purchase or lease option can be included in the Lease Agreement, or it can exist as a separate document. When drawing up your agreement, there are several important matters to consider, some of which differ from a regular rental arrangement:
Length or term of the lease: In lease-to-own arrangements, the lease term is 2-5 years on average, in order to give the buyer a chance to build equity in the home.
Purchase price: The property price is usually determined by a market appraisal. Often, the price is set higher than the property’s current value to account for future market fluctuations.
Option fee: Sometimes called an option premium, this non-refundable fee is paid in exchange for the right or option to buy. It is generally calculated at 2-7% of the property value.
Option deposit: Some owners allow buyers to pay a refundable option deposit towards the purchase. If the potential buyer decides not to go ahead with the purchase, the owner would return it.
Rent: Monthly rent is usually higher than market rate because a portion of each payment is credited toward the purchase of the home (usually it is set aside to help with the down payment). This is called a rent credit or sometimes a rent premium.
Other monthly payments: Who will be responsible for paying for utilities, repairs, insurance, and property tax? Who is responsible for covering condominium or homeowners’ association (HOA) fees?
What type of property are you renting?
The pros and cons for sellers
A rent-to-own arrangement can be a good option for homeowners and landlords who want to sell their property. However, before starting your search for a buyer, you should weigh both the advantages and disadvantages of a lease purchase agreement to determine if it’s the right decision for you.
Pros of renting to own:
- It can be difficult to find a buyer in a slow market. If you want to move but cannot afford to do so until you sell your property, a rent-to-own arrangement can generate cash flow to offset your current mortgage payments, allowing you to move to a new home.
- You can often set a higher purchase price on your home than the current market value. The option to purchase offers flexibility that potential buyers may be willing to pay a premium for, meaning you may be able to sell your property for a price higher than if you simply sold it outright.
- If you do not need to sell right away, renting to own has financial advantages, including an additional stream of income and tax deductions from being a landlord.
- In many cases, the tenant will take better care of the home knowing they may own it at a future date.
- If the tenant decides not to purchase at the end of their lease, you (the landlord) usually get to keep the option fee.
Cons of renting to own:
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Because the purchase price is fixed once the agreement is signed, your profit is also fixed. If home values go up, you are still obliged to sell your property at the price specified in the contract.
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If the tenant opts out of their option to purchase at the end of the lease, the seller must go through the process of finding a buyer once again.
The pros and cons for buyers
The road to becoming a homeowner isn’t always easy, and renting to own can facilitate the process. Just be sure to consider both the advantages and disadvantages before signing a lease with an option to purchase.
Pros of renting to own:
- If you don’t have enough for a down payment or cannot qualify for mortgage financing due to bad credit, renting to own can help get you on track. While you rent, you can work to improve your credit score as well as build equity in the home.
- You get to experience homeownership and decide whether it is a good fit for your lifestyle. You also have the chance to test out the neighborhood or area before committing to a longer term arrangement.
- If you decide to exercise your option to purchase at the end of the lease term, you can buy the home for the price you settled on when you created the agreement, regardless of whether real estate prices have gone up.
- Whether you decide homeownership isn’t for you or you don’t qualify for a mortgage, in most cases, you can opt out of the purchase at the end of the lease.
Cons of renting to own:
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Because rent credits are being applied to your monthly rent, the seller can charge more than the market rate. Consequently, your monthly payments will be higher than with a traditional rental agreement.
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Even if you want to buy the home, you may be unable to exercise your option to purchase if you do not qualify for mortgage financing at the end of the lease term.
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In most cases, you forfeit your option fee and any rent credits if you opt out of the purchase.
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There is a risk that the home will be foreclosed before you can buy it, as there is no guarantee the owner will continue to make mortgage payments while you are living there.
Buyer tip: Avoid the risk of foreclosure by inquiring about the mortgage payment history before signing your lease agreement. You should also inquire about any liens against the property with a title company or at your county recorder’s office, as this can affect the transfer of title from the seller to the buyer.
Exercising the option to purchase
Occasionally, a buyer will agree to a lease purchase, meaning they commit to buying the home when they sign the lease. However, most rent-to-own arrangements simply grant the tenant the option to purchase, in which case there are two possible scenarios at the end of the lease term.
A tenant who decides that the home or neighborhood isn’t a good fit, or who is unable to afford a mortgage can opt out of buying the home if need be. As per the rent-to-own contract, the landlord is usually entitled to keep the option fee, as well as any earned rent credits.
Alternatively, some tenants do decide to buy. In this case, the option fee and earned rent credits are applied toward the purchase. The terms of the sale, including financing details and closing date, can be documented with a Real Estate Purchase Agreement.
Aspiring buyers should determine whether they qualify for mortgage financing before the lease ends, so they can back out of the purchase if necessary. If the buyer is unable to obtain financing but still wishes to buy the property, the seller may be more comfortable facilitating the purchase with a Land Contract, also known as a Contract for Deed.
While a Real Estate Purchase Agreement transfers title of ownership right away, a Land Contract allows the seller to retain the property title until the home is paid off in full. The buyer continues to reside at the property while making monthly payments (with interest) toward the purchase. Once the home is paid off, the seller can use a Warranty Deed to transfer title to the new owner.
The renting-to-own process
It’s important to weigh the benefits and drawbacks before committing to a rent-to-own arrangement, and equally important to understand the terms and conditions of your contract. In fact, you might consider consulting a realtor or real estate attorney before signing the document.
However, in a tough market where a seller struggles to sell their home and an aspiring homeowner cannot meet strict loan qualifications, a lease purchase can be mutually beneficial to both parties.
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