Rent-To-Own: Fiction or Fact
In most circumstances, the buyer will purchase the home using a down payment, and a mortgage for the bulk of the remaining balance.
But what about people who haven't managed to save enough for a down payment or simply aren't in a position financially to purchase a home right now?
The good news is that if you are at a time in your life when you want to buy a home, but don't have enough spare cash to make a down payment, there is another option you can explore known as rent-to-own, sometimes also called a 'lease option.'
How It WorksFirst, you should note that not all states allow lease options on residential property and in those that do, contracts will almost certainly differ from home to home.
A typical scenario sees you (the tenant) renting a property for an agreed price over set period (usually one to three years). When that time is up, you have the option to purchase the home. You also have the choice to buy the home during the agreed lease period. You will be required to pay the seller a one-time, (usually) non-refundable fee called option money, which secures your opportunity to purchase the property at the end of the lease period.
How much rent you pay will depend on your agreement, but it's quite reasonable to pay slightly above market rate. If you end up purchasing the property at the end of the agreed period, the seller will credit a portion of your rental payments back to you, usually more than the portion, which was above market rate. You can use this money toward your down payment on the property or simply keep it.
The rental payments are usually above market rate to provide the seller with an incentive to complete the transaction. If you choose not to purchase the property, the seller gets to keep all of what you have paid over the agreement period, as well as your option money, a reality that compensates the seller for having taken their property off the market for the duration of the agreement.
The BenefitsThe primary benefit of rent-to-own homes is that they enable you to move in very quickly without having to save up a large cash deposit. They are also a good option for buyers who can't yet qualify for a mortgage.
For example, let's say you have had financial problems in the past and your credit score has taken a hit as a result. You've been steadily improving your credit rating, but you still don't quite qualify for a mortgage. A rent-to-own home will allow you to secure a property you like and afford you some extra time to fix your credit score, increase your savings or just generally get yourself into a better financial position. The purchase price of the home is locked in when the contract is signed, which means you can secure a house at a fixed price, without needing to worry about it increasing.
However, in a rapidly appreciating real estate market, it is common for the seller to add a clause into the contract, which allows the price of the home to increase over the period. Such a clause is particularly likely if the contract is for several years.
You will not immediately have to pay property taxes, private mortgage insurance or homeowner's insurance. Instead, you can put a bit of money aside to pay for these when the time comes. The seller will usually continue to pay for any maintenance costs and repairs to the home throughout the agreement term too, saving you as a buyer from having to fork out most of the repair costs that arise as a house ages.
You will get an extended “test drive” before you commit to buying, which allows you to fully assess whether the home is perfect for you before you make a serious financial commitment.
Even if you choose not to purchase the property at the end of the lease period, the only consequence (depending on your agreement) is that you will lose the portion of the rent you paid above market rate and the option money. For many individuals, such a scenario could be more attractive than being obliged to satisfy a significant financial commitment.
Common Pitfalls (for buyers)The entire rent-to-own industry isn't as tightly regulated as the home-buying or rental industries because it is less common. As a result, inexperienced buyers can sometimes be victimized by unscrupulous sellers who do not intend to sell the property at the end of the lease period. That's why it pays to read every small detail in your agreement and seek professional advice if you are unsure about any aspect.
As we mentioned before, not all states allow lease options on residential property, so you absolutely must ensure your agreement is legal before you sign anything.
There are also financial implications. While you don't need to have a substantial cash deposit before you move in, you do need to pay the option money and make payments above the market rate.
If you are not sure whether you will be in a financial position to purchase the property at the end of the agreement, you should probably reconsider. You will almost certainly lose the option money you paid; you'll pay rent above market rate, and are likely to have nothing to show for it all in the end.
So, if you are not sure whether you can secure a mortgage before the lease expires or get yourself into a more favorable financial position, a “normal” lease agreement is probably the best option for you. You can then spend a bit more time getting yourself into better shape financially and choose from a larger selection of homes on the traditional real estate market.
It's also important to remember that the final selling price of the house is usually agreed before the contract commences. Therefore, you could end up buying a house above market rate if its value declines during your lease agreement.
Lastly, rent-to-own contracts are often less flexible than traditional lease agreements. Moving out if your circumstances change may be more difficult, a good reason to be sure before you commit.
ConclusionRent-to-own arrangements can be a sound financial tool to help you get up the property ladder if you know what you are doing and just need some time. However, if you are unsure whether you will be in a position financially to purchase the property at the end of the lease period, a traditional rental agreement could be more suitable for you.
Before you embark on your rent-to-own journey, make sure you perform the same due diligence you would if you were buying a property the traditional way, and seek expert advice if you need to.