How Does Rent to Own Work?

“If you’re renting, you’re just throwing your money away.” No doubt you’ve heard this oversimplification many places. Of course, a decision about whether to rent or buy a home is rarely that black and white: Either can make sense depending on your situation.

What if there was a way to combine the benefits of both? A rent-to-own deal is that happy medium. When you rent to own, part of your rent goes toward purchasing the home at a later date. So instead of disappearing into thin air, your rent is literally laying the foundation for your future.

Sounds great, but as with any major financial decision, there are pros and cons to rent-to-own deals. We’ll discuss the basics of rent to own, its benefits and drawbacks, and a few alternatives below so you can make an informed decision on whether it’s right for you.

Rent-to-Own 101: How Does It Work?

The process starts, of course, with a contract. Actually, in this case, it starts with two: a rental agreement and an option to purchase. Here’s what you need to know about both:

Rental Agreement

Your rental agreement will look much like a standard lease. It will specify your rent amount and the term, which in most cases, will be two or three years.

There will be several standard terms and conditions you’ll need to meet: For instance, no smoking in the house, any pet restrictions, occupancy limits, and general conduct requirements. Violate these terms, and just like any tenant, you can be kicked out. However, this time, you also risk losing any money you’ve paid toward the home’s eventual purchase.

One big difference in this lease agreement: You will have more freedom to decorate or even renovate your home, but will also be responsible for day-to-day maintenance and minor repairs, instead of these being the responsibility of your landlord. This maintenance is generally limited to five hundred dollars. However, the landlord will still be on the hook for any major repairs like if the roof needs to be replaced or the furnace or air conditioner goes.

Option to Purchase

The option gives you the exclusive right to purchase the home, and is typically valid for a term equal to the lease term set out in your rental agreement. So if the rental agreement specified a three-year lease term, the option will usually give you three years to buy the house without worrying about anyone else snatching it out from under you.

To receive this right, you will typically pay an option fee. The amount can vary widely, with occasionally none being required, but 2% to 5% of the home’s purchase price is typical. This option fee is then credited toward the home’s purchase at the end of your term. However, if you decide not to buy, you’ll lose the money.

Make sure you’re signing a lease option, and not a lease purchase. Sometimes these terms are used interchangeably, but a lease option gives you just that — the option to buy the home. A lease purchase obligates you to buy the home and means the seller can take legal action if you try to back out.

How Much Does Rent-to-Own Cost Me?

First, let’s talk about rent. A certain percentage of your rent will usually go toward the purchase price of the home. This is something you can, and should, negotiate with your landlord. One thing to keep in mind when you negotiate: Because of this credit, you will likely be paying more to rent the home than you otherwise would. For instance, a house that would normally go for $1,000 a month might go for $1,250, with the extra $250 saved as credit toward the home’s purchase. So if you seek a higher credit, your rent may rise accordingly. Also note that your lease will probably specify that if you’re late paying rent, you’ll lose that month’s rent credit.

Next, let’s talk about the home’s purchase price. In most deals, you will agree to a purchase price upfront, typically a bit higher than current market value. In some cases, you may delay that decision until your lease term is up, or have the purchase price determined by an independent appraisal. Whether one or the other will be more beneficial hinges on whether the home’s value rises or falls during that time. A key point in either scenario, however, is that the purchase price is also negotiable — just like you’re buying a house the traditional way.

Let’s look at an example. You enter a two-year rent-to-own agreement for a townhouse. The option fee is 3% of the home’s $200,000 purchase price, or $6,000. This is due up front. Your monthly rent is $1,600, and 20% ($320) goes toward the purchase of the home every month.

At the end of your two-year lease term, assuming you exercise your option to purchase, the fixed $200,000 purchase price will be discounted by a) the amount of the option fee and b) the total rent credits. So subtracting the $6,000 option fee brings the price down to $194,000. Then, subtracting $7,680 in rent credits ($320 x 24 months) further reduces it to $186,320.

And remember: If you decide not to purchase the house, the option fee and credits are non-refundable.

Who Benefits Most From Rent-to-Own Agreements? Who Should Give It  a Pass?

For the right buyer and seller, a rent-to-own deal can be a win-win. But on both sides, as with any major financial decision, there are pros and cons you’ll want to note.

Pros for buyers

Rent-to-own can be worth looking into for would-be buyers who simply can’t obtain a mortgage the traditional way. Typically, that’s because you either lack enough cash for a down payment or your credit score isn’t strong enough to be approved for a mortgage (or both). With a rent-to-own agreement, you get more time to boost your credit and save up, all while getting a head start on building equity.

You may also benefit from a rent-to-own agreement if you are reasonably sure you want to stay in the house and neighborhood long-term, but still want to “try it out” while maintaining an escape route. If you can lock in a purchase price before the home’s value rises, you may be able to save in the long run, too.

Pros for sellers

Of course, there are some benefits for the sellers, too: They get a long-term tenant who has a stake in taking care of the property, and the non-refundable option fee helps reduce some of their risk if the buyer walks away.

They can often still get a top-of-market price and rent for the home, even in a weak market, because the tenant/buyer gets to start building equity from the get-go. They also won’t have to pay the real estate commission (usually 3%-5% of the purchase price) they would if they sold their home traditionally.

Cons for buyers

While a lease option gives you the sole right to purchase the home you’re renting, it doesn’t guarantee that you’ll be approved for a mortgage at that time. If you are unable to improve your credit or save enough for a down payment during your lease, you could still be shut out — and you’ll lose all the money you paid toward the purchase, too. To help protect against this scenario, experts recommend meeting with a mortgage lender before signing the deal to know exactly what you’ll need to qualify at the end of the lease, and begin working on improving your credit right away.

When you lock in a purchase price up front, you also risk watching the home’s value drop during your lease. If that happens, you could be stuck paying an inflated price for the home simply so you don’t lose your option fee and rent credits. Be sure to research home prices and do a home inspection before signing — these things will help you be more confident that the home is actually worth the price.

You also want to be sure your landlord is on solid financial ground before closing a rent-to-own deal. If he or she falls behind on the mortgage or loses the house for some other reason while you’re renting, you probably also lose the option to buy and all of the money you’ve put toward the purchase price. To help protect yourself, do a title search before signing anything so that you can make sure the property is actually your landlord’s to sell.

Finally, you should be wary of a rent-to-own agreement if you’re not absolutely sure you can be a model tenant during your term. Paying your rent late means you’ll probably forfeit that month’s credit, and violating any of the lease terms could get you kicked out of the home — minus, of course, your option fee and any rent credits you’ve paid.

Cons for sellers

The biggest con of rent-to-own for a seller is that if a willing buyer showed up on your doorstep offering full price (or more) for your home, you would have to refuse — your tenant’s lease option gives them that right exclusively during the contract term. If you lock in a purchase price initially (the most likely scenario), you may leave money on the table over a traditional sale if your home’s value climbs dramatically.

Finally, though they have a strong financial incentive to buy, there’s always the chance that your tenant will walk away at the end of their lease, leaving you at square one with a house you either have to rent again or sell.

Alternatives to Rent-to-Own Deals

It’s wise to evaluate other options before committing to a rent-to-own deal. Here are a few alternatives to consider before signing on the dotted line:

Seller Financing

Some sellers would prefer to sell the home to you right now without messing around with leases and options, and they may be willing to provide the financing for you. The downside is that they will typically require 20% or more down payment and a higher-than-market interest rate. They will, however, typically be willing to look past employment or credit issues that a commercial lender would not.

Private Mortgage

Sometimes available through mortgage brokers. The down payment and interest rate will likely be similar to seller financing, the difference being that you are borrowing from a private 3rd-party investor, rather than from the seller of the property.

Just continue to rent and save

This is your safe fallback option, and likely the one most financial experts would recommend. If you’re truly committed to saving up and building your credit, there may be little reason to jump the gun with a rent-to-own or private finance deal. After all, if you can afford the option fee and higher rent that these deals require, then put all that money you saved in a high-yield savings account or money market account. Continue to add to it by finding a place with lower rent, live below your income to save as much as you can, and give yourself the freedom to obtain a mortgage the regular way in the future.

How Do I Find Rent-to-Own Homes?

Unfortunately, finding rent-to-own homes isn’t quite as simple as finding properties that are for sale or rent. Searching for “rent to own” on classified sites like Craigslist or Kijiji can be a good free option.

You also have nothing to lose by reaching out to the owners of homes that are currently for sale or rent in your preferred neighborhood, especially if they’ve been on the market for a while. Ask the sellers/landlords whether they’ve considered doing a rent-to-own deal — they may be open to the option, especially if the home is vacant.

Finally, Homes Everyday works with a number of investors, lenders and brokers who specialize in purchasing homes specifically to rent-to-own to you. View our available homes and apply.