Though renting and buying are often treated as the only two options for acquiring housing, there exists a lesser-known third option in between called rent-to-own. When you sign a rent-to-own agreement, you’re agreeing to rent the property for a period of time with the option (or the hard commitment, depending on your contract) to purchase the property at the end of the lease, at which time a portion of the rent you’ve already paid will be applied to the price of the home.
Rent-to-own can be a great way to acquire a property, but only if you have specific financial needs. Those for whom rent-to-own is a poor fit could lose a lot by entering into an agreement that’s not in their best interest.
“[Rent-to-own] helps people with lower credit scores who otherwise wouldn’t qualify for a home loan,” says Gian Moore, an interior designer and real estate professional who worked in Seattle’s residential market for over 10 years.
But while rent-to-own can make homeownership more attainable, it can also be a huge risk. “Make sure you have the financial discipline and assured income to keep up the payment until the mortgage is paid,” Moore says. “Any default will lead to loss of significant amounts of money.”
So how do you know if rent-to-own is right for you? Read on or skip straight to our handy flowchart designed to help you decide.
Rent-to-Own Agreement Types
There are two main types of rent-to-own contracts: the lease-option agreement and the lease-purchase agreement.
A lease-option agreement guarantees the renter the opportunity to purchase their home in a rent-to-own arrangement at the end of the lease, but it does not require them to do so. If you decide during the duration of the lease that you’re no longer interested in living there long term, you can walk away when the contract expires, just like with any normal rental agreement.
If you sign a lease-purchase contract, you’re committing to buying the rent-to-own property at the end of the lease. If you sign this type of rent-to-own contract, you may be legally required to buy the home, even if you’ve decided against it or can’t afford to do so.
It’s important to note that there is no “standard” rent-to-own contract, so the language explaining what type the agreement you’re signing is may not be explicitly clear. “Get the contract vetted by a professional before signing one,” suggests Moore. “The clauses in these agreements can be heavily skewed in favor of the landlord.”
If you’re not already working with a real estate agent, consider getting a real estate lawyer to look over anything you plan to sign.
How It Works
When you sign a rent-to-own agreement, there are four things you and the seller will need to agree on: your purchase price, your monthly rental amounts, who’s responsible for home maintenance, and what your upfront costs will be.
When you enter into a rent-to-own contract, you and the seller need to decide whether to “lock in” a price at the time of signing or determine the price when the lease expires. Prices that are locked in ahead of time are typically higher than the property’s current market value, since real estate appreciates in value over time. However, locking in a purchase price may still save you money if you live in an area where housing prices are trending upward.
Your rent-to-own contract will also set a monthly rent amount, a portion of which will be applied to the down payment on your home. It’s normal for the monthly cost of a rent-to-own lease to be slightly higher than monthly rents in a given area to adjust for the fact that a portion of the payment is being converted into equity for the renter. However, the monthly payments shouldn’t be too much higher than local monthly rents, or you may find you’re better off signing a normal lease and saving a down payment independently.
Usually, maintenance and repairs for a rental property are the responsibility of the landlord, not the lessee. However, renters may be responsible for property maintenance if their lease is part of a rent-to-own contract.
Throughout the duration of the lease, the landlord or property owner will remain responsible for taxes and insurance, so they may choose to remain responsible for maintenance to keep related costs low. But since this isn’t a given, you should verify it before signing.
The final contract factor you and the seller need to determine is an upfront fee called the option consideration or option money. The option consideration is usually equal to between 1% and 5% of the purchase price and is what legally gives you the “option” to buy the home at the end of the lease. Like most elements of a rent-to-own contract, the option fee is negotiable, so feel free to haggle somewhat over the percentage.
Is Rent-to-Own Right for You?
“The best buyers of rent-to-own are people who don’t qualify for a traditional mortgage loan due to various reasons but have a stable and assured income,” says Moore. Though rent-to-own can make homeownership possible for those with a checkered financial history, the consequences for defaulting on a rent-to-own agreement can be steep, so it’s essential to be absolutely certain before entering into one.
How do you determine whether or not a rent-to-own property is the right choice for you? Here are a few of the pros and cons:
Benefits of Rent-to-Own
- You Can Purchase Without a Down Payment. One of the primary reasons a buyer might seek out a rent-to-own arrangement is so that they can purchase a home despite not having a down payment saved. Down payments can be as much as 20% of the purchase price, whereas the upfront costs associated with a rent-to-own contract are typically in the 1% to 5% range.
- You Can Improve Your Credit Score. If you have a down payment saved but your low credit score impacts the mortgage rates available to you, a rent-to-own contract can give you time to improve your finances and raise your score before taking over ownership of the property.
- You Can Pay Off Other Debts. Even if you’re a prime candidate for a mortgage, if you have other debts outstanding, you may be wary of adding the burden of a mortgage on your credit report. Rent-to-own can give you time to pay off these other debts before borrowing against your home.
- You Can Access Competitive Markets. One under-discussed benefit of rent-to-own is that it can help mortgage applicants access high-cost or competitive housing markets where mortgage requirements are more stringent.
Drawbacks of Rent-to-Own
- It’s Less Flexible Than Renting. While rent-to-own is undeniably more flexible than outright homeownership, it’s much less flexible than renting. If you find yourself needing to relocate, it’s much easier to break a lease than it is to exit a strict lease-purchase agreement.
- Markets Can Fluctuate. You can lose out on a rent-to-own agreement if markets fluctuate unexpectedly. If you lock in a purchase price on a lease-purchase agreement and then the markets collapse, you’ll find yourself paying much more for your house than it’s worth. On the other hand, if you sign a contract agreeing to determine your home’s value when the lease expires and housing prices spike while you’re still renting, you’ll have missed out on the opportunity to lock in a lower price.
- It Isn’t Free. While it can feel like converting a portion of your monthly rent into equity is an easy win, the flexibility comes at a price. Your monthly rent will be higher than normal for the area, and you’ll also need to pay a upfront option fee that’s nonrefundable and doesn’t count toward your purchase. It’s important to balance rent-to-own’s costs against its benefits to ensure you’re still getting your money’s worth.
- The Stakes Are High. “If the tenant defaults on the payment, the homeowner gets to keep the entire [investment],” notes Moore. During the lease period of a rent-to-own contract, the installments you make toward a down payment don’t convert into equity, so you’ll have no way to recoup your investment if you break the terms of the contract.
How to Find a Rent-to-Own Property
Rent-to-own homes are somewhat unique, but there are still plenty to be found as long as you know where to look. If you think rent-to-own might be the right choice for you, here are four places you can look.
Work With a Real Estate Agent
The first and simplest way to find a rent-to-own property is to work with a real estate agent who specializes in or has experience with rent-to-own contracts. Some real estate companies and brokerages even operate dedicated rent-to-own programs, which can be beneficial both in helping you identify available rent-to-own properties and in guiding you through what can be a complicated contract-signing process.
Negotiate With the Seller
Another way to find a rent-to-own arrangement is to proactively suggest it to a seller. If a seller’s home has been on the market for some time or they’re having a hard time selling it for some reason, they may be open to an alternative arrangement in order to get the purchase made. In this case, a rent-to-own arrangement can be attractive for both parties.
Look for a Reluctant Landlord
By the same principle, another prime candidate for proposing a rent-to-own contract is the dissatisfied landlord — someone who owns a property and is tired of handling the upkeep and management of renting it out long term. In this scenario, a rent-to-own proposal could be a good way for the owner to sell the property without having to go through the hassle of staging and showing it for a traditional sale.
Find a Pre-Foreclosure Property
Finally, pre-foreclosure listings are a great place to find sellers who are likely to be open to a rent-to-own arrangement. Often, homeowners who can no longer afford to pay their mortgage will avoid a full foreclosure through one of several arrangements they can negotiate with the bank. One such arrangement is called a pre-foreclosure or “short” sale. In this arrangement, a home that was due to be foreclosed is sold at a portion of the market price in order to keep a bankruptcy off of the owner’s credit report.
These short sale listings are often prime candidates for rent-to-own purchases since the owners are usually highly motivated to get their home off the market so they can start working to become solvent again.
Alternatives to Rent-to-Own
Even if you think rent-to-own might be a good fit for you, you should compare its benefits against some alternative options to ensure that rent-to-own really offers you the best deal.
Apply for an FHA Loan
If you want to buy a home, your finances are in good shape, and you’re simply missing the lump sum necessary to afford a down payment on a home, you might want to consider applying for a loan secured by the Federal Housing Administration (FHA). These loans are designed to help first-time buyers purchase their first home, and they have lower down payment requirements — as low as 3.5% of the purchase price — for those with a 580 credit score or higher.
If you can qualify for an FHA loan, you should do the math to see whether it would be less expensive for you to buy a home outright than it would to sign a rent-to-own agreement. A lower down payment comes with costs, usually in the form of mortgage insurance and higher interest paid over the life of the loan. However, these costs may be less than the fees and premiums associated with a rent-to-own contract, especially for those confident in their ability to refinance for better rates in a few years.
Build a Down Payment Independently
If you’re lacking a down payment and you have other debts or your credit score could use a little work, it may make sense to continue to rent while building a down payment independently.
Monthly rent on a rent-to-own contract is inflated slightly to account for the fact that some of the cost is being set aside for the renter’s down payment. But if the rent-to-own price is significantly higher than median rents in the area, you may be better off renting a more reasonably priced unit and setting aside a monthly down payment contribution on your own.
For example, say a rent-to-own lease price is set at $2,000 per month and 25% of the monthly rent ($500) is credited toward your housing purchase. Over the course of a two-year lease, you’ll spend $48,000 total on housing — $36,000 on rent, and $12,000 toward your home purchase.
Say, however, that a comparable property is available nearby for $1,200 per month. If you sign a two-year lease for this property and deposit a monthly $500 credit into a savings account of your own, you’ll build the same $12,000 down payment and save over $7,000 on rent. And if you put those monthly savings amounts in an account with 2% interest, you’ll net another $773.61 in the process!
The conclusion you draw from this comparison will vary widely depending on where you’re moving, rental prices nearby, and the specifics of the housing agreements you’re comparing. Only you can determine what the best deal will be for you.
Wait and Improve Your Credit Score
Some rent-to-own programs offer credit repair and financial counseling resources to renters, which can be an appealing prospect to those with low credit scores that are preventing them from buying a home the traditional way. However, you may find you can get a better deal on a property by waiting to improve your credit before buying a home.
As you can see in the example below, you may be able to set aside more, and spend less on rent, by signing a standard lease and saving up a down payment independently. If you spend the duration of that lease improving your credit score, you can save a significant amount in mortgage rates and interest as well.
Two years is more than enough time to raise your credit score by 100 points or more. According to FICO, that improvement (from a 620 to a 720, for example) would save a homebuyer over $41,000 in interest on a 30-year fixed-term mortgage worth $150,000.
In the end, deciding how to buy a home is a personal decision, one that requires some serious evaluation of your priorities and finances. The one thing that’s true of all scenarios, however, is that the only way to determine what’s right for you is by doing the math, researching your options, and making smart, well-considered financial decisions.