How Rent to Own Works: A Guide
Are you looking to become a homeowner within the next few years? Maybe you’ve looked into buying homes but can’t afford the upfront costs. Are you a student that wants to get a head start on the post-grad home buying process? Or perhaps you aren’t able to qualify for a loan due to a weak credit score.
If either of these sounds like you, we may have a solution. Our guide will walk you through all the pros and cons of rent to own homes. This type of renting is fairly common, but not many people know how to begin the rent to own process. After reading our guide, you’ll have a clear idea of how rent to own works, if it’s favorable for you, and if so, how to get started.
A Guide to Rent to Own Homes: Table of Contents
How Rent to Own Works
The Contract Basics
Pros & Cons of Rent to Own
Should You Rent to Own?
Getting Started with Rent to Own
How to Mitigate Risk
So What Now?
Helpful Links & Resources
How Rent to Own Works
Rent to own, also know as lease to own or lease option, is an alternative to traditional renting or buying. You could even think of it as a fusion of both, since rent to own is basically just leasing a home until you become eligible to buy it.
First, you’ll pay a small option fee upfront and during the leasing term, you’ll benefit by receiving rent credit that you can apply to future home expenses. For many buyers, this option is more financially sensible than purchasing a home at full price. Rent to own enables you to move into a house right away, even if you can’t afford a down payment or qualify a mortgage.
The rent to own process is pretty straightforward when broken down into four simple steps. We’ll go into more details about how complications can arise later on in the guide.
The Contract Basics
In every rental agreement, there are certain requirements you’ll need to follow. In this section of the rent to own guide, we’ll discuss the option to purchase contract basics as well as some key components you should keep in mind when choosing to rent to own.
No two contracts are exactly the same, though most share similarities in their fundamental ingredients. Here are the basic elements every option to purchase contract should include:
- Purchase Price
- Standard Rent
- Maintenance and Other Fees
- Option Fee
- Rent Premium
- Buying the Home
For your convenience, we have also created the Rent to Own Guide Contract Checklist and an example of a Rent to Own/Option to Purchase Contract below to make sure you have everything you need. Simply click the images to download them each as a PDF.
Besides reading this guide, you also may want to hire an attorney to help you review the contract since the terms can be a bit difficult to comprehend. Legal counseling can make your process run a lot more smoothly; a lawyer can ensure that you understand all of the rent to own conditions and minimize your risks of entering into a fraud agreement with a scammer.
1. Purchase Price
When entering into the option to purchase contract, you and the landlord will agree on a fixed price of the home. This price should be an estimate of the future fair market value of the home when the lease expires. You can check the current fair market value by using a Home Value Estimator. However, to estimate the future fair market value, you should consult a local mortgage banker for more accurate, expert advice.
Remember, the home price is locked in at the beginning of the lease and remains the same until it expires, regardless of whether mortgage rates change in the future. Moreover, you should always clarify with the landlord if you are obligated to buy the home if you can’t afford it at the end of the period. Failure to specify this may result in a lawsuit if you do not purchase the home when the lease expires.
2. Standard Rent
Just like in any rental agreement, you’ll pay a set amount of rent per month for the duration of your lease. It’s highly recommended to check if your base rent aligns with fair market value. You can do this by either contacting a local mortgage banker or using the online Rentometer tool. If they don’t align, you might not be able to use your credit towards the home purchase at the end of your lease, and you definitely don’t want that to happen.
3. Closing Timeframe
You’ll have to negotiate with the seller how long your lease will last; the rental term should be exactly how long you think it’ll take you to save up for the down payment, so be very cautious here. Furthermore, you should also confirm with the seller/landlord the dates of payment for the lease, the home’s actual mortgage, and other expenses that may arise. This will ensure everything is getting paid on time and prevent issues between you and the landlord in the future. You cannot continue to rent to own a property if it is foreclosed. So, make sure that what you pay the seller is enough to cover the mortgage and the seller isn’t in a pre-foreclosure.
4. Maintenance and Other Fees
It’s important that you clarify which person will cover the home’s maintenance charges, utilities, and property fees. Buyers who rent to own are typically held accountable for all maintenance, repairs, and utilities on the house, unlike that of traditional renting. For your reference, we’ve posted a link at the end of the rent to own guide to a list of maintenance expenses on rental property.
On the other hand, the landlord usually pays for property taxes and insurance since they are ultimately responsible for their home. You should also discuss matters such as renter insurance policies and home modifications during the contract drafting. Establishing awareness of these terms and conditions will help you to prevent issues later during the leasing period.
5. Option Fee
An option fee, also called option consideration, guarantees you the option to purchase the home in the future. Typically, the option fee is non-refundable and ranges from 2 percent to 10 percent of the purchase price. If at any point during the rental term you become qualified for a mortgage, you may purchase the home and use your option fee and rent credit towards your down payment.
Note: The option fee IS NOT OPTIONAL. In order to exercise an option to purchase contract and even be given the chance to purchase the home, you absolutely must pay the fee.
Here’s an example that hopefully will put things into perspective:
The home Tom wishes to rent to own has a purchase price of $150,000 and a down payment of $30,000 (20 percent of the purchase price). At the beginning of his lease, Tom needs to pay an option fee of $5,250 (3.5 percent of the purchase price). Since Tom’s option fee of $5,250 is credited to the down payment of $30,000, if he buys the home, he has already paid off 17.5 percent of his down payment (see below).
6. Rent Premium
In addition to the standard rent itself, you’ll also pay a rent premium, which is a percentage of your monthly rent cost that is applied towards the eventual home purchase. Rent premiums are also known as rent credits because they’re a portion of your rent that is credited back to you if you purchase the home. The percent is negotiable but usually, ranges from 15 percent to 25 percent of the rent price. So you’ll be paying more per month for rent than you normally would, but that’s only because you’re receiving credit towards the home purchase.
Some sellers actually charge you fair market value for the rent and credit a part of that to you if you purchase the home. It’s important to note that is a very good deal for the buyer, but it’s uncommon.
When your lease expires, if you decide to purchase the home, the total rent premium you have paid will be subtracted from the cost of the down payment. Only the rent premium, not the standard rent, goes towards equity in the home.
The rent credits have been stored in an escrow account by the seller, which is separate from the seller’s bank account. The money is given to the bank as part of your down payment along with your option fee when you buy.
However, if you cannot or do not wish to purchase the home, the seller gets to keep all the rent premium you have paid throughout the leasing term.
Using the same example as above, let’s look at how the rent premium works:
Let’s say Tom agrees to pay standard rent of $1,500 per month to his homeowner. Tom pays an additional $300 per month, which is to 20 percent of the standard rent. His total rent cost $1,800 per month. If Tom’s lease expires in three years, he will have saved up $10,800 total or 36 percent of the cost of the down payment (see below).
7. Buying the Home
So now you know exactly how standard rent, rent credit, and option fee works. But what happens once your lease ends? Let’s add up our total savings at the end of the lease period:
Since Tom’s option fee was $5,250 and his accumulated rent credit was $10,800, by the time his lease expires he has saved up $16,050, approximately 53.5 percent of the down payment (see below).
Regardless, let’s say at the end of the term you can’t afford to purchase the house or decide you’d rather not buy it. Unfortunately, the non-refundable option fee would expire, you’d lose all equity earned towards the home, and the seller would keep your option money and rent credit.
Potential risks such as this one are inevitable when using a lease option. This is why it’s important to treat a lease option as if you actually intend to buy the home and consider all the ins and outs. In the next section, we will discuss some of these factors.
Pros & Cons of Rent to Own
Renting to own has many benefits that could allow you to potentially save a lot of money in the long run. However, if you’re not careful, a lease option could damage you financially for many years. We’ll teach you all about the pros and cons of rent to own to ensure you make a wise real estate decision.
Pro #1: Build Equity and Improve Your Credit
Your rent premium is anticipated to apply towards your down payment, since the premium equals about 15-25 percent of your standard rent. This may not seem like a lot, but in a few years you could accrue several thousand dollars, compared to traditional renting.
The lease option is ideal for those who need to repair their credit history, since you don’t need good credit to qualify for a rent to own contract. This option can give you the opportunity to increase your credit score by keeping your balances low, paying your bills, and eliminating debt.
Pro #2: Ease Your Financial Burden
While renting to own, the financial obligations are significantly lighter compared to traditional home purchasing. Your basic requirements during the leasing term only extend to include your option fee, monthly rent, and maintenance fees. Here are common real-estate costs you do not have to worry about paying for while renting to own:
- Monthly mortgage
- Home insurance
- Property taxes
- Home loans
- Down payment
- Foreclosure costs
Pro #3: Agree on a Fixed Price
Having a set price for the home eliminates the uncertainty of changing market prices and guarantees you your ideal home if you can cover the necessary expenditures. Furthermore, having a fixed price creates the incentive for many to organize their personal finances and spending habits; you might even be able to purchase your home before the lease expires.
Another benefit of fixed prices is the potential for you to gain money if the set price is lower than the actual fair market value of the home when the lease expires. To understand this concept, let’s look at an example:
Say Tom and his seller under-estimate the fair market value of the home to be $150,000 three years from now. If the actual FMV turns out to be $170,000, Tom would gain $20,000 (see below).
Pro #4: Gain Familiarity With Home
While leasing to own, you’ll have the advantage of learning the pros
and cons of the home. Not only will you gain familiarity within the home, but you will also become accustomed to its respective neighborhood and city. You’ll also get to know the strengths and weaknesses of the home, as well as any improvements or repairs that need to be made before taking ownership.
Con #1: Undergo Strict Regulations
During the lease, buyers face strict regulations; punctuality is heavily stressed. If you don’t stay up to date with rent, even if you’re just one day late, it could have serious consequences. Your rent credit may become void, making it harder for you to afford the down payment at the end of the lease. Let’s see how late payments affect equity when renting to own:
Tom has monthly rent credit of $300, however, during his 36-month rent period, he made nine late payments. As a result, Tom would lose $2,700 total towards the cost of the house (see below).
Con #2: Subject to Unforeseeable Risks
Due to the uncertainty of future circumstances, it’s inevitable that buyers will be subject to risks during their time as a tenant. For instance, if you overestimate the price of the home, you’ll end up paying more money than the fair market value cost. Let’s look at how fixed prices can put you at risk of losing money:
Say Tom and his seller over-estimate the fair market value of the home to be worth $150,000 three years from now. If the actual FMV turns out to be $130,000, Tom would lose $20,000 (see below).
If you aren’t careful, the seller themselves could even put you at jeopardy. If they can’t afford to pay for the mortgage, taxes, and other payments on their property, the home could be foreclosed and you’d be forced to evict the premises. On the other hand, if the time comes for the contract to expire and you can’t purchase the home, it could result in a lot of acquired debt on your end.
Should You Rent to Own?
As we discussed in earlier sections of the guide, there are many benefits that come with rent to own. However, depending on an individual’s financial situation, it may not be worth it in the long run. Take our quiz below to evaluate if rent to own is really for you:
So perhaps after reading thus far in the guide, you’ve decided that Rent to Own just isn’t for you. Maybe your credit score is too low and you’re drowning in a sea of debt. Or maybe your savings are pretty high and you already have enough for a down payment or a mortgage.
Regardless, there are definitely other options out there and one of them is bound to work perfectly for you. In this next section we’ll explore some popular rent to own alternatives.
1. Land Installment
Also known as a land sale, contract for deed, or seller financing, this is a type of agreement where a buyer pays to obtain the title of a homeowner. You would make a down payment and monthly installments until you’ve paid the full price of the home. Normally, the mortgage has already been paid off or the landlord will pay it off before transferring the title.
2. Wraparound Financing
Wraparound financing refers to a type of agreement where the buyer assists the seller in making their mortgage payments until the full price of the house is paid off. In this situation, you’re probably unable to obtain a loan but have enough money to pay the down payment and monthly amount. Additionally, you must sign a promissory note agreeing on the given purchase price.
3. FHA Loans
The Federal Housing Administration’s mortgage program has been around ever since FDR installed it in the 1930’s and has been quite popular ever since. In this agreement, you can make a down payment on a home as low as 3.5 percent if you have a minimum credit score of 580 and meet other financial qualifications. It’s actually an insurance program, so you would be paying premiums in order to receive coverage on things such as potential lender losses.
4. Buy or Rent
Of course, you could always go the traditional route and either buy or rent a home. Buying a home would be a better alternative if you don’t necessarily need to rent to own because you can afford to make a down payment and qualify for a mortgage. Renting a home would be a better choice if you need a few more years to repair your credit and can’t afford the upfront costs.
Getting Started with Rent to Own
You’ve read through our guide, deliberated for some time, and finally decided that rent to own sounds like a good option. Getting started with the rent to own process might seem daunting because of all the responsibilities that come with it. However, with some advice and instruction we can put you in the right direction.
Let’s review our step-by-step strategy on how to rent to own:
Step #1: Decide on a Property
Start by looking for homes on the Internet. Luckily for you, we have millions of property listings on Rent to Own Labs from locations all over the country. Once you’ve narrowed down your top choices, contact the sellers and ask to see the homes. Meet them, get to know them, and ask questions. While touring the property, make sure you inspect as much as you can. Keep your eye out for things that look damaged or broken. In addition to the home, explore the neighborhood and city to determine if this is somewhere you’d like to live.
Step #2: Seek Advice From Expert Sources
After you pick a home, it’s pivotal that you conduct further background research. Consult a highly experienced mortgage loaner who can advise you on credit repair planning. A score of 580 is usually the minimum you must have to qualify for a loan, but some lenders only accept scores above 620. The higher your score, the easier it will be to receive financing for the home.
In addition, you should strive to educate yourself about the house’s history and confirm the seller’s credibility by investigating their former transactions. In order to ensure a successful rent to own leasing term, the seller must be a consistently reliable person.
Step #3: Establish the Option to Purchase Contract
After speaking to professionals, you should have a pretty general idea of what is expected of you as a rent to own tenant in an option to purchase contract. The last step you must make before moving into the house is to meet with your seller to develop the lease option arrangement.
While in the process of developing the contract, you may want to call upon a real estate lawyer several times to guarantee a full understanding of the different clauses within the agreement. Your lawyer can also assess the seller’s propositions and verify if they are trustworthy to ensure you won’t fall victim to legal scams.
Step #4: Move Into the Home
You’ve signed the option to purchase contract and now you finally get to move into the home. However, your work doesn’t stop there. Rent to own can be a quite rewarding system, but only if you apply more than just the minimum effort.
You’ll only get to reap the benefits if you work hard to build your financial profile during those few years of the term. In order to improve your profile within that span of time you must raise your credit score, consistently generate income, and save up for the down payment.
How to Mitigate Risk
When entering into any kind of legal contract, it’s important to be aware of the risks you may face in doing so. A buyer will often make the mistake of agreeing to rent to own without thorough consideration beforehand.
As a result, the buyer may be subject to the effects of his or her carelessness. In this section, we will show you how to diminish these risks so that it doesn’t happen to you.
1. Do Your Research
It’s crucial that you try to learn as much as you can about the home. Not having enough information is the biggest mistake you can make when entering an option to purchase contract. First, you should attempt to get ahold of the seller’s public records to find out if they’ve engaged in illegal activity in the past. Then, you should try to retrieve any available information about the property to make sure nothing suspicious or out of the ordinary has occurred. Lastly, you should evaluate your pros and cons.
2. Build Your Credit
One of the main reasons why buyers choose to rent to own over conventional renting is to improve their credit for the duration of the lease. Before purchasing a home you should always be realistic about your personal finances; if you are unable to obtain a mortgage loan when your lease term expires, you could lose your option fee and all of your equity towards the home. Therefore, it’s probably a smart idea to consult professionals before undergoing the rent to own process.
3. Actually Commit to the Home
As soon as you sign the option to purchase contract, you pretty much agree that you’ll buy the home. At least, it makes the most sense that you would. You paid the initial option fee and a rent premium to have the ability to purchase the house.
Think about it. If you decide after the lease expires that you truly don’t want to purchase the home, that’s thousands of dollars you’ll waste, and who wants that? Before entering into a rent to own agreement, you should always be serious about buying the home and not be on the fence about it.
4. Create a Backup Plan
So perhaps you followed all the steps in our guide about mitigating risk, but something still went wrong in the rent to own process. We must realize that in life many things are out of our control. However, it never hurts to have a backup plan so that the problems can get resolved as smoothly as possible.
For those worried about the seller managing your equity, you can secure legal protection of your payments with an escrow. An escrow account is a third-party account that holds and protects your money until your lease expires or you close. This will keep your rent credit and option fee out of the seller’s reach until a specific point in time.
So What Now?
To sum it all up, renting to own should be treated just as seriously as any other purchasing option. If your goal is to eventually own a home, this kind of decision shouldn’t be taken lightly.
Rent to own buyers are susceptible to risks and scams. It’s necessary to research and weigh the pros and cons before entering into the option to purchase contract.
I bet you’re wondering, what now? Are you ready to start looking for rent to own home listings? Or would you rather learn more about other related topics? Either way, we’ve provided multiple helpful links and sources down below to get you started.
Helpful Links & References
- Mortgages – A Beginner’s Guide
- How to Save for Your First Down Payment
- Here’s A Simple Guide To Improving Your Credit Score
- 6 Traps That Snare First-Time Renters
- List of Maintenance Expenses on Rental Property
- Field Guide to Buying Vs. Renting
- The Definitive Guide to Using Seller Financing to Buy Real Estate
- What Is a Wrap-Around Mortgage?
- FHA Loan – The Complete Consumer Guide
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