Everything You Need to Know About Rent to Own Agreements
March 6, 2017 by Marty Orefice | Contracts, Real Estate, Rent to Own
You understand rent to own, you found the perfect house and the owner wants to give you the lease option. You’re ready to move forward with the deal, but, wait. As you know, it is a big decision to begin leasing to own and over time you will invest a lot of money in the eventual purchase of the home. It's important to make sure that you are protected, legally. A contract ensures that the premiums you are paying each month will go towards your down payment. It also ensures that you are truly given the first option to buy the home.
What Should Go in the Lease to Own Contact?
This rent to own agreement sample is a good start to creating your lease to own contract.
While every lease to own contract is unique, all lease to own contracts should include these basic elements:
- Purchase Price
- Standard Rent
- Timeframe to Close
- Maintenance and Other Fees
- Option Fee
- Rent Credits
Download this pdf checklist to make sure your contract includes the most important elements.
Purchase Price
There are two options when it comes to figuring out a purchase price for a rent to own home. The first is deciding the purchase price based on what you and the seller anticipate the home's worth at the end of the lease. The second option is to decide on the purchase price when you close.
In the case where you decide the purchase price in the contract at the beginning of the lease, you and the seller will agree on the price for the home based on its future fair market value. Regardless of what the fair market value truly is on the date of purchase, you will pay what you and the seller agreed would be “fair market value.” A local mortgage banker can help you come up with a good estimate for the future fair market value.
If you were to wait to decide the purchase price when it's time to close, you can base the price on the fair market value at the time of purchase.
This is beneficial to both parties because there is a lot of risk associated with estimating what the market will do, even educated estimates from a mortgage broker.
If the market tanks below the price that you agreed to as a buyer, it's a lose-lose situation. You could back out of the deal and avoid overpaying for the property, but then you would lose your option fee and any rent credits you accumulated. The opposite is also true. If you decide to purchase the home you save the option fee and the rent credits but you over pay for the home.
The seller, on the other hand, gets a good deal in this situation because he or she sold the property at above the fair market value.
The same is true for the seller. If the seller sets a certain price with you and the market skyrockets, the seller loses the opportunity to have made more money on the property. However, in your benefit, you will have built equity in the home by buying it for less than it was worth.
It's also important to make sure the contract specifies whether you're required to purchase the home at the end of the contract if you can't afford it at the end of the contract. You want to make sure your rent to own contract legally protects you from lawsuits if you don't purchase the home.
Rent Credits
You can ask the seller to give you back a percentage of the rent you pay each month as an added incentive to purchase the home.
If the seller isn't keen on that idea, you can ask the seller to match an amount of money that you put in. For example, if your rent is $1,000, you can negotiate with the seller so that he or she contributes $100 of that money to an escrow account if you also contribute $100 to that escrow account.
A rent premium is a percentage of your monthly rent price that is saved in an escrow account and goes toward the down payment of the home should you purchase it. You will pay more per month for rent than you would for a normal rental property. However, the seller gives that money back to you as a credit towards the home purchase. So, if fair market rent is $1,000, you pay $1,100 and $100 of that is contributed to an escrow account.
If you choose to purchase the home, the entire rent premium goes toward your down payment. If you choose not to purchase the home, the seller keeps all premium payments.
Standard Rent
Base your rent on on the fair market rent for the property. Look at the rental price for similar properties in the area to make sure that you're paying an accurate amount for the property. It is also a wise idea to consult with a mortgage banker about the property's rent.
The rent to own agreement should specify your payments due date for each month. It's important to have written confirmation in the lease to own contract about what dates you will pay rent. Make sure to stick to these dates of payment to avoid nullifying the contract.
How much of the payment is going toward rent and how much is going towards your down payment? Make sure that your contract includes the exact amount. Your premium payments should align with the length of time and amount of money you need to save up for your down payment.
In some scenarios, you will not have premium payments. This is rare, but in some rent to own situations, sellers charge you fair market rent and credit a portion of it to your down payment. This is called a rent credit.
In this scenario, the seller is not aiming to penalize you for walking away from buying the property. Instead, the seller is giving you back some of the money you would have paid to rent anywhere as an incentive for you to purchase the home.
Most sellers will not give you this option, but if one does, this particular facet of the contract is a very good deal.
Timeframe to CLose
Prior to when the lease starts, you and the seller need to decide on a time frame to close. That timeframe is typically anywhere between one and three years. The timeframe you set should depend on how long it takes for you to close. There are pros and cons to short and long timeframes.
It's best to explain the two with examples.
The first is an example of why doing a short lease would be a good idea.
A tenant moving to an area on short notice might not have the time to qualify for a mortgage and close immediately. Renting to own means that you can rent until you're ready to purchase the home and then purchase that same home. Unlike a normal renting situation, you aren't actually trapped in the full length of the lease. In rent to own, you can close as soon as you are ready to.
The second is an example of a situation when a longer lease would be a good idea.
You know the home you want to purchase and you want to start building equity in it. However, you've met with a mortgage broker, and you know that your credit score will take at least 18 months to improve. In this situation, you would be best to go with a two or a three-year lease. You will can close as soon as you're ready because you aren't trapped in a conventional lease. However, you have the time to bring up your credit score. Plus, you'll have the opportunity to save up for the down payment, which should improve the mortgage terms too.
Maintenance and Other Fees
Technically speaking, in a rent to own scenario, you act as the owner of the home. While you don’t have the deed in hand, you still have to make and pay for repairs to the property. However, the situation isn’t entirely black and white. The owner might still pay for insurance and taxes on the home. It’s important to have these details in the contract before you sign a lease to own contract.
Typically, the owner pays for property taxes and insurance and the renter pays for maintenance charges, utilities and property fees. Ensure that your contract specifies who exactly pays what to avoid confusion.
Option Fee
Option fees are a required part of rent to own agreements. The fee guarantees you the first option to purchase the home in the future. It is a non-refundable fee and is usually between two percent and 10 percent of the price of the home. It will be credited towards the down payment of the home should you purchase it.
If you choose not to purchase the home, you will forfeit the option fee and the seller will keep it.
It is important to note that the seller must give you the first option to buy the home up until the point the lease ends. The seller cannot find another seller during the lease option and ask you to purchase at that point or forfeit. You retain the right to take the full timeframe specified in the lease.
At any point during the lease, if you are qualified, you can use the option fee and your rent premiums to purchase the home. The contract should state the amount of the option fee, where the seller will keep the money and how you can access it to purchase the home.
A little-known fact about option fees is that they do not need to paid in cash. While cash payments are the typical arrangement, any legal trade can be made in exchange for the option fee so long as the seller and buyer agree.
That means you could use anything from a boat to a motorcycle to gift cards to handyman services to pay the option fee, should you and the seller agree.
What Questions Should I Ask a Real Estate Lawyer About the Contract?
There are certain precautions you should take to protect your rights before signing a rent to own agreement form. It's always a good idea to have a real estate lawyer look over the contract before you sign. The real estate lawyer may suggest valuable revisions to the contract.
Have you asked the lawyer these rent to own agreement questions? You will feel a lot safer about signing your lease to own contract if you do!
1. Can I assign my option rights to someone else?
Assigning option rights means at a later date you can assign the option to someone else and charge them for the down payment that you paid. Option fees that are assignable, sellable or transferable work that way.
So, if for some reason you decide you don’t want to purchase the home, at any point throughout the lease, and you want to move somewhere else, you don’t lose your money. You can sell your position in the contract to someone else and recover all of the money you spent. That person would pay you for your spot and continue to make payments to the owner. At the end of the contract, that person has the option to buy the home. If you choose to do this, you would no longer have the first option to buy the home at the end of the contract. If this sounds like a possibility to you, ask your lawyer to include something about it in the contract.
2. Does the entire premium price go toward my future down payment?
Make sure that the seller isn’t overcharging you. Your full payment equals the fair market value rent plus the premium that gets put into escrow. If you’re paying more, call the owner out on it before buying the property and find out why the seller is overcharging you.
For example:
The fair market rent is equal to $600. Of what you pay each month, $50 is put in escrow. You should be paying the seller $650 per month.
3. Are there any liens or claims against the home? Is the home collateral for anything?
Basically, do your due diligence to make sure the seller does not pass any debt onto the house that ends up passed on to you if you choose to buy. Ask the seller, but take what he or she says with a grain of salt. Visit a public records office to look up the history of the financial records for the home and to perform an unofficial background check on the seller.
An unpaid contractor or employee can place a lien on the owner’s home. The amount the owner owes is passed on to the house until the owner pays off the debt. While the owner SHOULD pay it off when he or she sells you the home, you want to make sure to have it in your contract. It’s a possibility that the owner doesn’t even know about the lien on his or her home. For that reason, make sure to go the extra mile beyond what the seller says to research this question.
Did the owner put the house up for collateral to buy another property or to secure financing for something else? Include something about it in the contract. Be wary that the owner could foreclose on the home if, for some reason, he or she doesn’t make the payments on the collateral financing. Also, make sure that if you buy the home, the home is no longer collateral for that financing. Ask your lawyer to include something about the collateral in the contract. You don't want to risk losing the home once you’ve bought it because of the previous owner’s debt.
For other potential hazards to look out to, check out 5 ways to spot a rent to own scam.
4. Does the Seller Have a Mortgage on the Home?
Finding out about the owner's mortgage payments will help keep you secure. Be sure you can live in the home for at least the time specified in your lease. The owner may not be able to pay off the mortgage every month and could foreclose on the home if the mortgage payment is higher than your rental payment.
While this would be a scenario where you would probably get excess payment back, you cannot purchase the home or live there for as long as you expected. It won’t directly hurt you, but moving and looking for a new place to live takes time and effort. Especially if you’re looking for another rent to own property, which are rarer. Moving costs are also expensive, and you may have to take time off from work. If the reason you are renting to own is to improve your credit, the owner foreclosing could have unintended repercussions for you.
