Rent-to-own allows potential purchasers to lease a home with the opportunity to purchase it later. These arrangements can benefit both buyers and sellers, but it’s critical that everyone recognizes the dangers.
Learn how rent-to-own works, the benefits and drawbacks of such agreements, and the considerations that buyers and sellers should make.
Rent-to-Own Definitions and Examples
Traditional home loans can be replaced with rent-to-own agreements. At first glance, such agreements resemble typical leases that landlords and tenants might sign. The contract does, however, grant the tenant exclusive rights to acquire the residence at a future date. A portion of the money paid up in advance and as part of the monthly rent is applied to the purchase price.
Such an agreement can be made between any two parties, although it is frequently utilized as a part of housing projects aimed at establishing inexpensive homes or revitalizing areas.
What Is Rent-to-Own and How Does It Work?
In their contract, the buyer and seller agree on a purchase price for the home. The buyer can buy the house for that amount at some point in the future, regardless of how much it is truly worth.
To account for predicted gains in property values, it’s typical to establish a price that’s higher than the existing price. Things work out to the buyer’s advantage if the home’s value has increased faster than planned. The renter can pull out of the agreement if the house loses value. When it comes time to buy a house, most buyers apply for a mortgage.
Rent-to-own arrangements are divided into two categories. Lease-option agreements provide the tenant the option to purchase the property at the end of the lease term. The obligation to do so is established in lease-purchase agreements.
Buyers usually pay an option premium upfront, which can be as much as 5% of the final purchase price. Although the deposit is non-refundable, it can be applied to the down payment.
Is Rent-to-Own a Good Investment?
Some buyers will benefit from rent-to-own deals, while others will not. Rent-to-own may be the best option for you if you have bad credit or need time to save for a down payment. Much relies on your financial situation as well as the position of the housing market.
In a home market, the price-to-rent ratio indicates the relative affordability of buying vs. renting. It’s computed by multiplying the average price of properties sold in a particular market over a 12-month period by the average monthly rent in that same market.
For example, in the first quarter of 2021, the average price of a home sold in the United States was $403,600, but the average monthly rent paid globally was $1,124.45. To calculate the price-to-rent ratio, multiply 403,600 by 13,488 (1,124 multiplied by 12) to get 29.92. The higher the ratio, the more attractive the rental market is. The smaller the ratio, the better the market for purchasing.
Of all, average property prices and rentals differ from market to market, so the national average is only a rough guide. To be precise, you must base your calculations on current numbers in the area where you intend to buy or rent. The ten cities in the United States with the highest and lowest price-to-rent ratios are listed below.
Buyers’ Pros & Cons of Rent-to-Own
- Buy with bad credit: With a rent-to-own agreement, buyers who do not qualify for a home loan can begin the process of purchasing a home. They can concentrate on restoring their credit ratings over time, and when the time comes to buy the house, they may be able to receive a loan.
- Lock in a purchase price: In markets where home values are rising, buyers can contract to buy at today’s price with a purchase date several years down the road. If property prices decrease, buyers have the option to pull out, albeit whether or not this makes financial sense will depend on how much they have paid under the arrangement.
- Test drive: Buyers can take it home for a test drive before deciding to buy it. As a result, they will be aware of any faults with the house, as well as nightmare neighbors and other issues, before it is too late.
- Move less: Buyers who are devoted to property and area (but unable to purchase) can get into a home that they will eventually purchase. After a few years, this decreases the cost and difficulty of moving.
- Build equity: Renters do not, technically, build equity in the same manner that homeowners do. Payments, on the other hand, might add up to a significant sum that can be applied toward the purchase of a property.
- Money forfeited: If you do not purchase the home, you forfeit all of the extra money you spent. Sellers may try to make it tough or unappealing for you to buy so that they can keep your money.
- Slow progress: You may intend to improve your credit or increase your income in order to qualify for a loan when the option expires, but things may not go according to plan.
- Having less control: You don’t own the property yet, therefore you don’t have complete control. You could not be in charge of critical repair decisions if your landlord stops paying mortgage payments and loses the home to foreclosure. Similarly, your landlord may lose a lawsuit or stop paying property taxes, resulting in liens on the property. All of these eventualities should be addressed in the agreement. While the landlord cannot sell while you have an option on the property, court battles are always a significant headache and expense.
- Prices are dropping: You might not be able to renegotiate a lower purchase price if home prices decline. Then you have the choice of either forfeiting all of your option money or purchasing the house. You’ll need to bring extra money to closing for a down payment if your lender won’t accept an enormous loan.
- Late payments are inconvenient: If you don’t pay your rent on time, you may forfeit your right to purchase, as well as all of your extra payments, depending on your agreement. In some circumstances, you can keep your selection, but your extra monthly payment will not be counted and will not be added to the amount you’ve saved up for a future purchase.
- Home issues: There may be issues with the property that you are unaware of until you try to purchase it, such as title issues. Treat a rent-to-own transaction as if it were a real purchase. Before you buy, have a home inspection and a title search.
It is critical to seek advice. Rent-to-own agreements are particularly perilous for purchasers, and some scams target people with bad credit who have great aspirations of purchasing a property. Even with a trustworthy vendor, if things don’t go as planned, you could lose a lot of money. A real estate attorney should review any contract.
Sellers’Pros & Cons of Rent-to-Own
- More buyers: If you’re having difficulties attracting buyers, consider marketing to renters who want to buy in the future.
- Generate money: If you don’t need to sell right away and want to put the money toward a new down payment, you can earn rental income while you wait to sell.
- Higher price: When you offer rent-to-own, you have the option of asking for a higher sales price. People may be prepared to pay a premium for the chance. Renters also have the option of purchasing the home, which they may or may not use, but flexibility always comes at a cost.
- Invested renter: A potential buyer is more likely to take care of a property and get along with neighbors than a renter who has no investment. The renter/buyer has already invested in the property and is concerned about its upkeep.
- No certainty: Your renter might not buy, which means you’ll have to start looking for a new buyer or renter all over again—but at least you’ll get to retain the extra cash.
- Slow money: You don’t get a large lump sum of money, which you might need to buy your next home.
- Missing appreciation: When you sign a rent-to-own arrangement, you usually lock in a sales price, but home prices may climb quicker than you anticipated. You must either accept this or wait a time before presenting the choice to purchase.
- Falling home prices: If your renter does not buy, you would have been better off selling the house.
- Discovering flaws: Buyers may uncover weaknesses you were unaware of, leading them to decide not to purchase. The plumbing, for example, maybe acceptable for a couple, but not for a family of five. Despite the fact that this flaw was never noticed during the prior living arrangement, it is now something you’ll have to address or disclose to potential buyers.
In a rent-to-own agreement, everything is negotiable. Certain terms are agreed upon by both the buyer and the seller, and all of the terms can be adjusted to suit everyone’s needs.
Important Points to Remember
1. Rent-to-own contracts allow potential homebuyers to lease a home with the possibility to purchase it later.
2. The contract gives the renter the option to purchase the house at a later date.
3. A portion of the monthly rent is applied to the home’s purchase price, allowing the leaseholder to save for the down payment.
4. Buyers usually pay a nonrefundable premium up the advance, which can be as much as 5% of the total purchase price.