Rent-to-own homes are properties rented by individuals who intend to buy the property at the end of their lease term. Typically, the renter and the property owner sign a rent-to-own agreement that states the agreed selling price and includes an upfront option-to-buy fee.
Both parties can benefit from this type of agreement. The seller continues to receive rental income until the home is sold, and the buyer has time to save for a down payment, build their credit score if necessary, and shop for a mortgage. But there are potential downsides as well, such as the tenant losing their fee or the seller dealing with a renter who tries to renege on their arrangement.
In this guide, you’ll learn such information as:
• How does rent-to-own work?
• What are the two types of rent-to-own contracts?
• How does a rent-to-own contract benefit the seller?
• What should sellers know about entering into a rent-to-own contract?
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What Are Rent-to-Own Homes?
Rent-to-own homes are properties that a renter plans to buy from their landlord after a set period, often between one to three years. This type of arrangement benefits potential buyers who otherwise may not be able to follow the traditional home-buying process. Perhaps they have a low credit score or can’t afford a down payment right away. If so, this type of arrangement gives the buyer time to improve their financial situation and save for a down payment. For instance, it might be a wise move for some first-time homebuyers.
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How Do Rent-to-Own Homes Work?
So how does rent-to-own work? Here is how this kind of an agreement might unfold:
• First, know that there are two kinds of rent-to-own arrangements. With a lease option, you usually have the choice of buying the home at the end of the lease or walking away. With a lease purchase, you are entering into an obligation to buy the property at the end of the rental term. (You’ll learn more about the differences between these deals in a minute.)
• The monthly rental price may be higher than the market rate determined by the cost of living in your state or area. The reason why: The amount paid will often include rent credits. What are rent credits? This is money put toward the downpayment on the home when the lease is up and the renter moves forward with buying it. Discuss and read any agreement carefully before signing to understand any rent credit provision.
• If you are entering into a deal with rent credits, here’s how the math might look. Say the price of the home is $100,000. A tenant-buyer might put $5,000 toward a down payment. This could be paid as an additional $416.67 per month above the standard rental price over the course of a year-long lease.
In this rent credit example, the tenant-buyer would only need to borrow $95,000 since they have paid the homeowner $5,000 already. For people committed to renting to own, this is a way to build equity sooner. However, if you walk away from the property at the end of the lease in a lease-option arrangement, that rent credit money may not be refunded.
• The renter may also pay a nonrefundable upfront fee. This is called an “option fee” and gives the renter the option to buy the house when the lease ends. Option fees are typically between 1% to 5% of the home’s value. If the renter chooses not to buy the house, they likely lose the money.
The Process for Selling a Rent-to-Own Home
A renter typically has one to three years to exercise an option to buy a home. The process for the seller generally includes the following:
1. Prepare the necessary legal documents that detail the agreement — lease-option or lease-purchase. A lawyer may consult to draw up this paperwork. Rent-to-own agreement terms vary, and it is a good idea for tenants to also consult a lawyer to make sure their agreement suits their situation.
2. Collect a nonrefundable deposit and option fee (typically, this is 1% to 5% of the purchase price). The deposit will go toward the down payment for the house.
3. Collect monthly rent for one to three years. A portion of the rent may go toward the eventual purchase of the home and lower the amount paid at the end of the lease term.
4. If the two parties signed a lease-option agreement, the renter has the option to buy the home after the agreed amount of time. If the renter decides not to buy, the seller usually keeps the down payment money collected.
5. If the renter signed a lease-purchase agreement, the renter must purchase the home after the agreed amount of time and at the agreed-upon price. If they don’t do so, the tenant will usually lose the money paid for fees and the rent credits. In addition, the seller can sue them for breach of contract.
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Pros and Cons of Selling a Rent-to-Own Home
The biggest pro for sellers regarding a rent-to-own home is that they stand to make more money. The biggest downside to selling a rent-to-own home is that there is no guarantee a renter will close the deal.
The Advantages of Selling a Rent-to-Own Home
The list that follows highlights some of the key pros of selling via a rent-to-own arrangement.
• The seller can earn rental income while preparing to sell the property.
• This is useful if they have to move, buy another home, and pay two mortgages.
• Sellers often earn additional rent by offering rental credits on a property, which provides an income stream.
• Sellers keep the upfront option fee paid by the renter should the renter decide not to buy the property. They may also keep the rent credits.
• Sellers will likely sell the home for a better price than the market price because there are typically no real estate commissions paid out.
• A renter who plans to buy the home may be more motivated to pay on time and more inclined to take care of the property, lowering the seller’s maintenance costs.
The Disadvantages of Selling a Rent-to-Own Home
Next, consider the cons of entering into a rent-to-own arrangement.
• There is no guarantee that a renter will buy the home at the end of the lease. They may not be able to qualify after shopping around for a mortgage or have enough for a downpayment despite making payments toward it.
• The renter may fall delinquent with payments and refuse to vacate the property when the lease is up.
• The renter may not take care of the property if they decide not to buy it.
• The seller may be responsible for the upkeep of the property for the rent-to-own lease period.
• The seller is responsible for any unpaid utility bills the tenant falls behind on bill payments.
• The seller could wind up having to take legal action if a renter agrees to buy the home at the end of the lease but then refuses to do so.
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When Rent-to-Own Works
These rent-to-buy arrangements can have their benefits. Here’s how rent-to-own can work for the seller and the buyer.
• A rent-to-own agreement can benefit a potential buyer by giving them time to build their credit score and save for a down payment while learning about the mortgage loan process.
• The seller benefits because they still receive rental income during that time rather than leaving the home vacant while they try to sell it. In addition, the seller may receive above-market rent as the tenant accrues their down payment. They may also save on some of the expenses of selling a home.
When Rent-to-Own Doesn’t Work
While rent-to-own homes can work, this arrangement may not be the right choice for all sellers. Some points to consider:
• It can take time, perhaps years, before the renter is financially equipped to buy the home. So if the seller needs money now, this is probably not a good option.
• Also, if home prices are dropping, the seller may want to sell the home sooner rather than later. Or, since the home price is often determined in advance, the tenant might look for a price adjustment to reflect market conditions.
• Conversely, if home prices rise and the property’s selling price was previously set, the seller might feel as if they are missing out on the opportunity to reap a higher figure for the property.
• Lastly, a seller might regret entering into a rent-to-own agreement if the tenant finds problems with the home and demands a lower purchase price.
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Types of Rent-to-Own Contracts
As mentioned briefly above, there are two main types of rent-to-own agreements: lease option and lease purchase. Both types of arrangements allow the renter to buy the home at the end of what is typically a one- to three-year term, but there are some key differences to the agreement requirements.
Lease-Option Agreement
With a lease-option contract, the renter pays an option fee when they sign, which is typically around 1% to 5% of the purchase price of the home. Built into the rental payments are usually rent credits, which is extra money set aside for a down payment from the renter. The purchase price of the home is probably decided in advance, though sometimes it is only set when the lease agreement expires. If the latter, the price will be based on a home appraisal.
The renter can still decide not to buy the home at the end of a lease-option contract, but they will lose the rent credit amount they have paid and forfeit the option fee.
Lease-Purchase Agreement
With a lease-purchase agreement, the renter still rents the home for usually one to three years, and a percentage of the rent goes toward the down payment. In addition, the purchase price is typically determined upfront.
The difference with this type of agreement is that the renter is obliged to buy the home when the lease is up.
If the renter cannot buy the home at the end of the lease (say, they decide to move to another area or they can’t qualify for a mortgage), they lose their claim to the home and the money put toward the down payment. In addition, the seller may sue them for breach of contract.
How to Sell a Rent-to-Own Home
If you are selling a home as a rent-to-own property, heed this advice:
• It’s a good idea for sellers to first establish a rental agreement with the renter before entering into a lease-purchase or lease-option agreement. That way, the seller can claim a deposit for the property in case the renters do not take care of it or they drop out of the contract.
• The option-to-buy agreement will likely stipulate the price of the home, the option-to-buy fee, and the rent credits that will go toward the purchase price.
• The option-to-buy agreement can provide the owner/seller with the document they need if they have to evict the renter. This could occur if the tenant refuses to buy the home or to leave at the end of the lease term.
• With a lease-purchase agreement, the document drawn up will be legally binding and specify the arrangement for the tenant to buy the home at the end of the rental term. If the tenant should fail to buy the property at the end of the lease, the seller could sue.
• In both of these scenarios, it can be wise to have legal counsel to advise and to draw up documents.
Ask the Right Questions Before You Sign the Contract to Sell
First, manage your expectations. There is no guarantee that tenants who sign a rent-to-own agreement will ultimately buy the home. Many don’t.
However, two aspects are under your control:
• Consult with a skilled real estate lawyer who can structure the paperwork to protect your interests. Their expertise can help you avoid feeling as if you are losing money if your tenant leaves at the end of the lease.
• Also, property owners can maximize the likelihood of a sale if they choose their tenants wisely. You can ask for references from previous landlords and look into a potential renter’s employment history to assess their ability to pay rent and ultimately qualify for a mortgage.
The Takeaway
Rent-to-own contracts can be beneficial for both buyers and sellers. For buyers who cannot qualify for a mortgage because they have poor credit or do not have enough for a downpayment, renting to own can give them time to save for a down payment and build their credit score.
For sellers in this scenario, they continue to collect rental income until the home is sold rather than leaving the property vacant until they find a buyer. This is particularly valuable if they are buying another home and taking on two mortgages. The seller can also save money on real estate commissions and other aspects of selling a home.
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FAQ
What are two benefits of owning a home vs. renting one?
Buying a home is an investment. Over time, the value of the home can increase, and, as the owner pays down the mortgage, they build equity and wealth. Another advantage of homeownership: potential tax deductions. The home mortgage interest deduction can allow homeowners to deduct the mortgage interest from their taxable income, thereby reducing their tax burden.
Can you rent-to-own a house in California?
Yes, you can rent-to-own a house in California. However, as with rent-to-own agreements in any area, each party should be aware of the pros and cons of the arrangement. There are financial and legal implications to consider for both the tenant and the seller.
What is the meaning of lease-to-own?
Lease-to-own, or rent-to-own, usually means that the tenant pays rent on a property for a number of years and has an option to purchase it at the end of the lease. In some cases, at the beginning of the rental period, the tenant commits to buying the home at a specific price in the future.
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