In a typical home purchase, the sale takes place shortly after the offer has been accepted, and the transaction is completed at closing. Since most buyers don’t have the money to pay cash, a mortgage is usually used to finance the purchase: The buyer puts down a certain percentage of the purchase price (the down payment), then pays the lender in regular installments over a period until the balance is paid off in full.
To qualify for a mortgage; however, potential buyers need to have a good credit score and cash for a down payment. Without these, purchasing a home in the traditional way may not be an option. There is an alternative: a rent-to-own agreement. When buyers sign this kind of contract, they agree to rent the home for a set amount of time before exercising an option to purchase the property when or before the lease expires.
Here's how rent to own works, and when it may be a good choice for someone looking to buy a home.
Elements of a Rent-to-Own Contract
In a rent-to-own agreement, potential buyers get to move into a house right away, with several years to work on improving their credit score and/or saving for a down payment. While many states have their own regulations, and no two rent-to-own contracts are alike, someone in a rent-to-own agreement typically rents the property for a set amount of time (usually one to three years), after which he or she can purchase the house from the seller. It’s not as simple as paying rent for three years and then buying the house: Certain terms and conditions must be met, in accordance with the contract.
Option Money: In a rent-to-own agreement, the potential buyer pays the seller a one-time, usually non-refundable fee called option money, or option consideration. This gives him or her the option to purchase the house in the future. It is important to note that some contracts (lease-option contracts) give the potential buyer the right but not the obligation to purchase when the lease expires. If he or she decides not to purchase the property at the end of the lease, the option simply expires. If the wording is "lease purchase," without the word option, the buyer could be legally obligated to purchase the property at the end of the lease. Clarifying the wording is one of many reasons buyers should have the contract vetted by a real estate attorney before agreeing to it.
The size of the option is negotiable. There's no standard rate. It typically ranges between 2.5% and 7% of the purchase price. In some (but not all) contracts, all or some of the option money may be applied to the purchase price at closing. That's a valuable clause. Consider that if a home has a purchase price of $200,000 and a 7% option consideration, the buyer would need to pay $14,000 up front.
Purchase price: The contract will specify when and how the purchase price of the home will be determined. In some cases, the buyer and seller agree on a purchase price when the contract is signed – often at or higher than the current market value. In other situations, the buyer and seller agree to determine the price when the lease expires, based on market value at that future point in time. Many buyers prefer to “lock in” the purchase price if possible, especially in markets where home prices may be increasing.
Rent: During the term of the lease, the potential buyer pays the seller a specified amount of rent, usually each month. The lease term is negotiable but frequently ranges between one and three years. In many contracts, a percentage of each monthly rent payment is applied to the purchase price. For example, assume the contract states that the buyer will pay $1,200 each month for rent and that 25% of that will be credited to the purchase. If the lease term is three years, the buyer will earn a $10,800 rent credit to apply toward the purchase ($1,200 x 0.25 = $300; $300 x 36 months = $10,800). Often, the rent charged by the seller will be slightly higher than the “going rate” for the area to accommodate the rent credit the buyer receives.
Maintenance: Depending on the terms of the contract, the potential buyer may be responsible for maintaining the property and paying for any repairs, homeowners association fees, property taxes and insurance. Because the seller is ultimately responsible for association fees, taxes and insurance (it’s still his or her house, after all), the seller may choose to cover these costs. Even in that case, the buyer still needs a renter's insurance policy to cover losses to personal property and provide liability coverage if someone is injured while in the home or if the buyer accidentally injures someone.
Be sure that maintenance and repair requirements are specified in the contract. Maintaining the property – mowing the lawn, raking the leaves and cleaning out the gutters – is very different from replacing a damaged roof.
Purchasing the property: If the potential buyer decides not to purchase the property (or is unable to secure financing) at the end of the lease term, the option expires. The buyer forfeits any money paid until that point, including the option money and any rent credit earned. If the buyer cannot purchase the property but has a legal obligation to (as stated in the contract), legal proceedings may be initiated.
If the buyer wants to purchase the property, he or she typically applies for financing (i.e., a mortgage) and pays the seller in full. According to the terms of the contract, a certain percentage of the option money and rent paid may be deducted from the purchase price. The transaction is completed at the closing, and the buyer becomes a homeowner.
Ideal Candidates for Rent to Own
A rent-to-own agreement can be an excellent option for people who want – but are not financially ready – to become homeowners. A rent-to-own agreement gives them the chance to get their finances in order (by improving their credit score and saving money for a down payment, for example) while “locking in” the house they’d like to own. If the option money or a percentage of the rent goes toward the purchase price, they also get to start building some equity.
To make rent-to-own work, potential buyers need to be confident that they’ll be ready to make the purchase when the lease term expires. Otherwise, they will have paid the option money – which could be substantial – and a premium on rent for 12 to 36 months, with nothing to show at the end.
If there’s a good chance would-be buyers still won’t be able to qualify for a mortgage or secure other financing by the time the lease expires, they should instead continue renting (with a “normal” lease), building credit and saving for a down payment. Then, when they’re ready, they can choose from any home on the market in their price range.
The Bottom Line
A rent-to-own agreement allows potential buyers to move into a house (maybe even their dream home) while getting their finances in order to purchase the home several years in the future. It’s not without risks since they could end up losing money if they don’t (or cannot) buy the property when the lease expires. It’s vital for buyers to read and understand every word of the contract and know exactly what they’re getting into.
For example, if the contract can become void if the buyer is late on one payment – he or she needs to know that in advance. Or if the seller can evict the buyer for not doing repairs, that needs to be understood before committing. A rent-to-own agreement is a legally binding contract that often includes complicated language. Even if a real estate agent assists with the process, it is essential for buyers to consult with a qualified real estate attorney who can clarify the contract and their rights, before signing anything.