If you're at a place in your life where you'd really rather not be living in an apartment but you don't have the money to buy a home yet, an in-between option can get your foot in the door faster. It's called "renting-to-own" or a "lease option". Before you consider this type of arrangement, you should be aware of how it works, who benefits and the many things that can go wrong. (Are you ready to take the homeownership plunge? Find out in To Rent or Buy? The Financial Issues.)
How You Can Rent to Own
In a lease option, you rent a property at a cost slightly above market rate. Prior to moving in, you agree on a potential purchase date and purchase price for the home. You may buy the property at any point during the rental period up until the lease option expires. The lease option period can be any length of time that you and the seller agree to, ranging from several months to several years. (To learn more about the rental agreement, see Are You Ready to Rent?)
If you do purchase the property, the seller will credit part of your rent back to you, usually more than the portion of your rent that was above market rate. You can put this money toward a down payment and closing costs, or keep it. The purpose of the above-market rent is to give the seller an incentive to complete the transaction. If you do not purchase the property, all of the rent you paid remains with the seller, giving the seller an incentive for taking the property off the market during the time you were renting it.
Note: Not all states allow lease options on residential property, so the buyer should ensure that the contract is legal.
How It Benefits Sellers
One of the main reasons why a seller might be interested in a rent-to-own arrangement is because if an owner is having trouble selling, rent-to-own provides an alternative to lowering the home's price, taking the home off the market, or renting the home out long term. Because a selling price is established in the lease-option contract, the current homeowner knows exactly what to expect if a sale goes through. If the market declines slightly during the lease period, the sale price is already locked in, but the tenant will probably still be interested in buying the property because of the rent money rebate. Meanwhile, the owner gets help paying the mortgage, property taxes and insurance. Also, unlike a traditional rental agreement, the tenants are more likely to take care of a lease-option property because they have the option to purchase it.
How It Benefits Buyers
The main reason why a rent-to-own agreement appeals to buyers is a financial one. If buyers don't yet have the down payment or the monthly income to qualify for a mortgage but believe they will within the next couple of years, a lease option allows them to accelerate the path to homeownership. By signing a contract now, the buyer locks in a purchase price, which means no worrying about rising home prices. (Note: In a rapidly appreciating real estate market, the seller of a lease-option property would probably want to add a clause to the contract allowing for the price of the home to increase with the market.)
The buyer also does not have to worry about coming up with the money for property taxes, private mortgage insurance or homeowners insurance, and the seller will usually continue to pay for and complete any maintenance and repairs on the home. Finally, by living in the home before deciding to purchase it, a buyer has the advantage of a lengthy test drive on the home before jumping into a major financial commitment. Best of all, if the buyer decides to walk away from the deal, the only consequence is the loss of that portion of the rent paid that was above market rate. If the buyer ends up purchasing the property, the seller will credit part of the rent back to the buyer, often more than the portion of rent that was above market rate. (To read more about mortgages, see First-Time Homebuyer Guide, Understanding The Mortgage Payment Structure and Shopping For A Mortgage.)
Potential Pitfalls for Buyers
Of course, everything doesn't always come up roses with lease options. A would-be buyer should be aware of the many things that can go wrong in the process before getting involved in a rent-to-own agreement. Before entering a rent-to-own agreement, a potential buyer should:
- Check the seller's credit report. Look for potential warning signs that the seller is in financial trouble, such as delinquent accounts or a large amount of outstanding debt. Even after a satisfactory credit check, a potential buyer who currently lives in the home should still pay attention to any warning signs that would indicate that the seller is in financial distress. Some examples include phone calls from debt collectors and suspicious-looking notices that are sent to the house.
- Recognize that the seller could lose the property during the rental period. This could occur for any number of reasons such as if he or she is unable to make the mortgage payments, a tax judgment is placed on the property, he or she goes through a divorce, is being sued, and so on. If the seller loses the property, the potential buyer loses the possibility of buying the property, forfeits the extra rent paid and will have to find a new place to live. There is one possible exception: if the home becomes bank-owned through foreclosure, the bank might consider selling the home as soon as possible to the rent-to-own buyer in order to avoid the hassle of maintaining and marketing the property to a different buyer. In this case, the rent-to-own buyer would have to decide whether the purchase is feasible at the new date.
- Ensure that the lease option clearly states who is responsible for various types of maintenance or repairs. This agreement should also specifythe types of changes or improvements (if any) the potential buyer is allowed to make to the property during the lease term.
- Be sure to enter a "lease-option agreement"rather than a "lease-purchase agreement". The former grants the option to buy at any time during the rental period,while the latter requires purchase by the end of the lease period and has legal ramifications for backing out.
- Do market research and obtain a home inspection. This is how you can ensure that the home purchase price is fair before signing a contract.
- Be aware that if the seller is unscrupulous, he or she can refuse to sell at the end of the lease-option period. This means that all the above-market rent money you've paid will be lost. A seller may also try to back out of the contract if the real estate market has appreciated rapidly and the property significantly increases in value. Of course, neither of these actions is legal, but if the buyer doesn't have the financial resources to hire a lawyer, there won't be much recourse against a shady seller.
- Understand that if the market declines, the buyer will still have to pay the higher price stipulated in the contract to own the home. However, if the price is too high, the lessee can just walk away and shop for a different property. However, the buyer will lose that portion of the rent that would have gone toward a down payment, so it's important to do the math necessary to determine whether walking away is the best option.
- Talk to a mortgage broker and ensure that you're in a position to buy the property. This is because even if the lessee decides to buy the house, it is possible that he or she will not qualify for the mortgage loan required to make the purchase. Finding this out before entering a rent-to-own agreement, therefore, can save a lot of grief down the line.
- Obtain a condition of title report. This can help a buyer learn how long the seller has owned the property. The longer the seller has owned it, the more equity and stability he or she should have built up in it.
While rent-to-own arrangements can have many potential pitfalls, they can be a win-win situation between a trustworthy seller and a prudent, financially responsible buyer. If you can find an arrangement that you can agree on and a house that you'd like to own one day, this could be the perfect way for you to step out of your apartment and put down some roots.