Homeownership is the American dream. However, this dream demands a well thought-out financial plan and years of savings to cobble together enough money for a down payment. It is equally critical to maintain a high credit score by paying bills on time.
What if, instead of saving for a new house while renting another one, you could buy the rented house itself? Does it sound too good to be true? This is what the rent-to-own model is - where you, as the tenant, have an option to buy the house you are renting.
What are Rent-to-Own houses?
During the financial crash of 2008, the rent-to-own model gained popularity and became a viable and somewhat common alternative for tenants. Rent-to-own houses work on a simple model: a portion of each month’s monthly rent is set aside to save enough for a down payment in an amount sufficient to eventually buy the house. The lease-purchase contract is a legal agreement, with an average lease duration of three years, that binds both the tenant and landlord to the pre-negotiated terms. Over this time period, the tenant earns credit towards the purchase price of the home.
How does Rent-to-Own work
Depending on the real estate market situation and the relationship between the tenant and landlord, the rent-to-own process varies. However, a typical rent-to-own transaction entails the following steps:
Negotiate the purchase price: The rent-to-own agreement explicitly highlights the mutually agreed purchase price. This price is based on the home's current valuation —or in some cases, the tentative price when the lease expires.
Decide the monthly rent deductions: As part of the contract, the monthly rent is revised by a percentage to allocate some amount toward the purchase of the home. This revised rent is higher than the average rent for a comparable home in the area.
Discuss maintenance and repairs coverage: The seller may ask the tenant to cover additional costs like maintenance, repairs, property taxes, and HOA fees at the time of renting. Therefore, it's critical to review the contract with an estate attorney.
Payment of Option fee: Tenants have to pay a mandatory one-time, non-refundable amount known as the Option Fee. Since there is no standard amount, most landlords demand a percentage of their home's purchase price.
Agreeing on the Lease term: The tenant and landowner agree on a mutually convenient, specific lease term in the contract. If the lease ends and the tenant is unsure about the purchase or fails to qualify for financing, the offer to purchase the home expires.
Final Closing process: It is important to secure financing well before the end of the lease term. Once the closing date is set, the ownership of the property is transferred to the buyer. As per the agreed terms, the percentage of rent money set aside as option money is then credited to the tenant.
It's particularly important to note that the rent-to-own process is not as regulated as a typical purchase or rental transaction. Since no standard rules apply to the rent-to-own contract, the terms are entirely negotiable. So, ensure you contact an experienced real estate agent and attorney before striking a deal.
Analyzing the pros & cons
Split the down payment amount: The rent-to-own model allows tenants to gradually save enough for a down payment and to build equity over time by paying a slightly higher rent.
No buyer competition: Since the rent-to-own agreement is made in advance, there will be no competitors for the home’s purchase.
Bad credit isn’t a hurdle: Buyers who don’t qualify for home loans can begin buying a house thanks to the rent-to-own agreement. So, this allows the tenant to rebuild their credit scores over time, and apply for loans when it’s time to finally buy the home.
Qualification for a mortgage is delayed: Those repaying a debt or unable to pay the down payment amount upfront can still move into a house without qualifying for a mortgage. However, it is best to work out a financial plan to clear off any unpaid bills before drafting the agreement.
Test live: Buyers can live in homes before deciding to buy a property. Consequently, buyers learn what problems the house may have and can therefore make a well-informed decision.
Lock in a purchase price: In markets where home prices are steadily increasing, the rent-to-own agreement essentially allows buyers to lock in or fix a price several years in advance.
Rent is more expensive: Although a portion of the rent is allocated toward the future purchase of the house every month, even this small increase in rent can pose a large financial challenge for many renters.
Additional fees like maintenance and option fees: Tenants have to shell out a non-refundable percentage of the home's price and costs for repairs and maintenance. These unexpected expenses may not be reimbursed if the deal does not proceed and the tenant does not end up buying the home.
Fluctuating valuation of real estate: It is not uncommon for home values to go up and down. There is no way to predict the future accurately, so locking in a purchase price long before the purchase takes place could turn out to be a great boon or a terrible decision if purchase prices move in an unexpected direction.
Slow progress: Your plans of rebuilding credit scores might not work out, and you might not qualify for the home loan after all.
Viewing things through the buyer’s lens
As a buyer, before you rent-to-own, make sure you are ready to purchase your own house. Since it’s a significant investment, carefully consider your plans about moving. Once you have conviction about your near-term plans, start exploring the rent-to-own listings. If you are working to improve your credit, rent-to-own could be the perfect option for you.
Before you sign a rent-to-own lease from your landlord, ensure that you qualify for a pre-approved mortgage at the purchase price specified in the contract or lease. If you fail to meet these basic requirements, renting to own may not be the right option. It is also essential to take into account anticipated inflation, since the purchase price may be adjusted for it.
For example, consider this scenario with the following terms and conditions:
- The rent-to-own lease has rental payments of $1,450
- The $1,450 includes a consistent $250 per month contribution towards a down payment
- The purchase price is $250,000
In over three years, you would have accrued $9,000 toward a down payment, which roughly equates to 3.6% of the purchase price.
Understanding the seller’s perspective
Like any other home, sellers can list their homes as a rent-to-own (or lease-to-own) home. However, the buying process, in this case, is very different from a typical home-buying process.
In many cases, rent-to-home sellers have houses that have been on the market for a long time, so rent-to-own can be a great way to liquidate their real estate. The rent-to-own option attracts potential buyers by allowing them the flexibility to buy a home while gradually building their credit. As a seller, you need to make sure your potential buyers have a sufficiently high credit score to qualify for a loan when the time is right.
It is also recommended that you hire an experienced attorney to draft a contract or lease for you, the seller, since there are no standard templates for these kinds of lease transactions.
The most common benefits of selling your house through a rent-to-own agreement include less concern over of fluctuating market prices and better quality tenants.
Alternatives to the Rent-to-Own process
A quick analysis of rent-to-own homes reveals that the cons slightly outweigh the pros. Therefore, it is vital to keep your options open for the future. The alternative to the rent-to-own process is the traditional, tried-and-tested way of buying a house.
Pay off overdue bills and work on your finances generally. Cutting down on irrelevant expenses by renting and saving for an emergency fund are among the best practices for future buyers. Once your accounts are organized, you can start setting money aside for the down payment.
It’s best to take this leap only after you have created a solid financial plan. This will take work and sacrifice, but it will be a worthwhile endeavor! Simply put, avoid investing in a rent-to-own home unless you know what the rent-to-own model holds for your future home.
6 Expert Tips Before You Sign the Contract
- Understand the terms of the agreement: It is always advisable to enter into a lease-option agreement rather than a lease-purchase agreement. Never buy a house—or sign any housing agreement--when you are in financial dire straits!
- Ask for help: Hire a knowledgeable real estate attorney to explain the contract, your rights, and obligations upfront.
- Research the contract: You must understand the deadlines and due dates, the option fee, structure of rent payments, maintenance fees (and what that might include) and restrictions (such as pets, if any).
- Ask to see the home’s paperwork: Demand a property inspection and make sure the property taxes are in good standing. It is also important to check that there are no liens on the property.
- Conduct background research on the seller: Verify the seller’s credit report to identify any financial misses. Ask for a title report to see how long the landlord has owned the property.
- Re-read the fine print: Make sure you read the terms and conditions correctly before signing. If you need clarity or want to propose changes to any terms, make sure to consult your attorney.
Unraveling the risks
Non-refundable fees and additional payments: As part of the rent-to-own agreement, the buyer needs to pay the seller a mandatory one-time non-refundable fee known as the option fee. This fee provides the option to buy the house at a later date in the future. Since there is no fixed regulation on the standard rate, the option fee is negotiable. On average, the fee ranges anywhere between 1% and 5% of the purchase price.
Lease-Purchase contract: There are two types of rent-to-own contracts - lease-option and lease-purchase. Although these contracts sound very similar, they are very different from each other. A Lease-option contract hands you the right to buy the home when the lease expires; however, it is not mandatory.
The option expires if you decide against buying the property. You cannot be forced to continue paying rent or even buy the property. This isn't always the case with lease-purchase contracts.
- A rent-to-own agreement is ideal for those who are willing to commit to renting a property for a specific period, with the option of buying it before the lease runs out.
- Renting to own can be a path for those who wish to own a home, but do not yet have the financial means to do so through a more traditional route.
- This model gives buyers a chance to work on their finances, improve their credit score, and accumulate money for a down payment while living in their own house that they can fix up and make their own.
- Lease-option contracts provide buyers with the freedom and flexibility to buy homes upon lease expiration. However, lease-purchases mandate the buying decision.
- A non-refundable one time fee, known as the option fee, is to be paid by the buyer to reserve the right to buy in the future.
- Some rent-to-own contracts may include terms like maintaining the property and paying for repairs before the closing date.
Investing Opportunities with Republic
Before deciding to invest in a rent-to-own situation, it is advisable to talk to an experienced real estate agent. These agents can help to explain your options given the current market conditions and help you to make an informed decision for your future.
Or you could hop on to a platform like Republic, where all listed properties are reviewed and vetted by Republic’s real estate team and any applicable intermediary.
We are talking about the real estate market that's worth a whopping $8.9 trillion. What's stopping you from owning a piece of it? Republic strives to empower individuals with the expertise they need to be decisive and invest wisely in the booming real estate market.
It’s natural that you have more questions, so here are some FAQs that go into more detail and will help you to gain a better understanding of the real estate market.
This educational article is provided by Republic to help its users understand this area of the market, it should not be construed as investment advice as it is impersonal, disinterested and was produced by Republic for Republic’s users, without remuneration received or expected.