If you’re like most home buyers, you’ll need a mortgage to finance the purchase of a new house. To qualify, you must have a good credit score and cash for a down payment. Without these, the traditional route to homeownership may not be an option. (For more, see The Ins and Outs of Seller-Financed Real Estate Deals.)
There is an alternative, however: a rent-to-own agreement, in which you rent a home for a certain amount of time, with the option to buy it before the lease expires. Rent-to-own agreements consist of two parts: a standard lease agreement and an option to buy. Here’s a rundown of what to watch for and how the rent-to-own process works. It's more complicated than renting and you'll need to take extra precautions to protect your interests. Doing so will help you figure out whether the deal is a good choice if you're looking to buy a home.
You Need to Pay Option Money
In a rent-to-own agreement, you (as the buyer) pay the seller a one-time, usually nonrefundable, upfront fee called the option fee, option money or option consideration. This fee is what gives you the option to buy the house by some date in the future. The option fee is often negotiable, as there’s no standard rate. Still, the fee typically ranges between 2.5% and 7% of the purchase price. In some contracts all or some of the option money can be applied to the eventual purchase price at closing.
Read the Contract Carefully: Lease Option vs. Lease Purchase
It’s important to note that there are different types of rent-to-own contracts, with some being more consumer friendly and flexible than others. Lease-option contracts give you the right – but not the obligation – to buy the home when the lease expires. If you decide not to buy the property at the end of the lease, the option simply expires, and you can walk away without any obligation to continue paying rent or to buy.
Watch out for lease-purchase contracts. With these you could be legally obligated to buy the home at the end of the lease – whether you can afford to or not. To have the option to buy without the obligation, it needs to be a lease-option contract. Because legalese can be challenging to decipher, it’s always a good idea to review the contract with a qualified real estate attorney before signing anything, so you know your rights and exactly what you’re getting into.
Specify the Purchase Price
Rent-to-own agreements should specify when and how the home’s purchase price is determined. In some cases you and the seller will agree on a purchase price when the contract is signed – often at a higher price than the current market value. In other situations the price is determined when the lease expires, based on the property's then-current market value. Many buyers prefer to “lock in” the purchase price, especially in markets where home prices are trending up.
Know What Your Rent Buys
You’ll pay rent throughout the lease term. The question is whether a portion of each payment is applied to the eventual purchase price. As an example, if you pay $1,200 in rent each month for three years, and 25% of that is credited toward the purchase, you’ll earn a $10,800 rent credit ($1,200 x 0.25 = $300; $300 x 36 months = $10,800). Typically, the rent is slightly higher than the going rate for the area, to make up for the rent credit you receive.But be sure you know what you're getting for paying that premium.
Maintenance: It May Not Be Like Renting
Depending on the terms of the contract, you may be responsible for maintaining the property and paying for repairs. Usually, this is the landlord's responsibility so read the fine print of your contract carefully. Because sellers are ultimately responsible for any homeowner association fees, taxes and insurance (it’s still their house, after all), they typically choose to cover these costs. Either way you’ll need 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 you accidentally injure someone. (For more, see 6 Good Reasons to Get Renter’s Insurance.)
Be sure that maintenance and repair requirements are clearly stated in the contract (ask your attorney to explain your responsibilities). Maintaining the property – e.g., mowing the lawn, raking the leaves and cleaning out the gutters – is very different from replacing a damaged roof or bringing the electric up to code. Whether you’ll be responsible for everything or just mowing the lawn, have the home inspected, order an appraisal and make sure the property taxes are up to date before signing anything.
Buying the Property
What happens when the contract ends depends partly on which type of agreement you signed. If you have a lease-option contract and want to buy the property, you’ll probably need to obtain a mortgage (or other financing) in order to pay the seller in full. Conversely, if you decide not to buy the house – or are unable to secure financing by the end of the lease term – the option expires and you move out of the home, just as if you were renting any other property. You’ll likely forfeit any money paid up to that point, including the option money and any rent credit earned, but you won’t be under any obligation to continue renting or to buy the home.
If you have a lease-purchase contract, you may be legally obligated to buy the property when the lease expires. This can be problematic for many reasons, especially if you aren’t able to secure a mortgage. Lease-option contracts are almost always preferable to lease-purchase contracts because they offer more flexibility and you don’t risk getting sued if you are unwilling or unable to buy the home when the lease expires.
Who's an Ideal Candidate for Rent-to-Own
A rent-to-own agreement can be an excellent option if you’re an aspiring homeowner but aren’t quite ready, financially speaking. These agreements give you the chance to get your finances in order, improve your credit score and save money for a down payment while “locking in” the house you’d like to own. If the option money and/or a percentage of the rent goes toward the purchase price – which they often do – you also get to build some equity.
While rent-to-own agreements have traditionally been geared toward people who can’t qualify for conforming loans, there’s a second group of candidates who have been largely overlooked by the rent-to-own industry: people who can’t get mortgages in pricey, nonconforming loan markets. “In high-cost urban real estate markets, where jumbo [nonconforming] loans are the standard, there is a large demand for a better solution for financially viable, credit-worthy people who can’t get or don’t want a mortgage yet,” says Marjorie Scholtz, founder and CEO of Verbhouse, a San Francisco–based start-up that’s redefining the rent-to-own market.
“As home prices rise and more and more cities are priced out of conforming loan limits and pushed into jumbo loans, the problem shifts from consumers to the home finance industry,” says Scholtz. With strict automatic underwriting guidelines and 20% to 40% down-payment requirements, even financially capable people can have trouble obtaining financing in these markets.
“Anything unusual – in income, for example – tosses good income earners into an ‘outlier’ status because underwriters can’t fit them neatly into a box,” says Scholtz. This includes people who have nontraditional incomes, are self-employed or contract workers, or have unestablished U.S. credit (e.g., foreign nationals) – and those who simply lack the huge 20% to 40% down payment banks require for nonconforming loans.
High-cost markets are not the obvious place you'll find rent-to-own properties, which is what makes Verbhouse unusual. But all potential rent-to-own home buyers would benefit from trying to write its consumer-centric features into rent-to-own contracts: The option fee and a portion of each rent payment buy down the purchase price dollar-for-dollar, the rent and purchase price are locked in for up to five years, and participants can build equity and capture market appreciation, even if they decide not to buy. According to Scholtz, participants can “cash out” at the fair market value: Verbhouse sells the home and the participant keeps the market appreciation plus any equity they’ve accumulated through rent “buy-down” payments.
Do Your Homework
Even though you’ll rent before you buy, it’s a good idea to exercise the same due diligence as if you were buying the home outright. If you are considering a rent-to-own property, be sure to:
- Choose the right terms. Enter a lease-option agreement rather than a lease-purchase agreement.
- Get help. Hire a qualified real estate attorney to explain the contract and help you understand your rights and obligations. You may want to negotiate some points before signing or avoid the deal if it's not favorable enough to you.
- Research the contract. Make sure you understand:
- the deadlines (what is due when)
- the option fee and rent payments – and how much of each applies towards the purchase price
- how the purchase price is determined
- how to exercise your option to buy (for example, the seller may require you to provide advance notice in writing of your intent to buy)
- whether pets are allowed
- who is responsible for maintenance, homeowner association dues, property taxes and the like.
- Research the home. Order an independent appraisal, obtain a property inspection, make sure the property taxes are up to date and ensure there are no liens on the property.
- Research the seller. Check the seller’s credit report to look for signs of financial trouble and obtain a title report to see how long the seller has owned it – the longer they’ve owned it and the more equity, the better.
- Double check. Under which conditions would you lose your option to buy the property? Under some contracts, you lose this right if you are late on just one rent payment or if you fail to notify the seller in writing of your intent to buy.
The Bottom Line
A rent-to-own agreement allows would-be home buyers to move into a house right away, with several years to work on improving their credit scores and/or saving for a down payment before trying to get a mortgage. Of course, certain terms and conditions must be met, in accordance with the rent-to-own agreement. Even if a real estate agent assists with the process, it’s essential to consult a qualified real estate attorney who can clarify the contract and your rights before you sign anything.