There’s no question about it, buying a home takes research and work. Especially if it’s your first home and you need financing. You start saving for a down payment and closing costs, then spend your free time trolling realty websites for that perfect Dutch Colonial with quartz countertops until your eyes glaze over. Instead of swiping left on potential dating partners, you’re swiping left on any house with hardwood floors.
Once you find the one, the perfect house, you may have to figure out if you can actually buy it if you have not yet gone through the Pre-approval process with a lender. And the real work begins—from deciding if you are eligible for zero or low down payment loan options to exploring if you want to go with a larger down payment in exchange for a lower monthly payment to comparing interest rates from various mortgage financing companies.
How Do Rent to Own Agreements Generally Work?
Some of the options you may come across during this process are “rent to own” or “lease with option to buy” , these options vary but in general they come in with two forms, a home rental lease and a contract to buy or for an option to buy.
With this type of agreement, the renter commits to renting the property for a specific period of time (typically the length of the rental term) with the option (or obligation) to buy anytime before the lease period expires depending upon the contract you settle on.
In many cases the renter places a deposit upfront (option fee) to lock in the option to buy later, which is usually 1% of the agreed upon price and then makes higher than market monthly rent payments that include both the regular rent payment and the additional amount agreed upon to go towards the down payment at the time that the option is exercised.
At first glance, a rent to own property may seem like a great way to get into your dream house before you’re totally ready to buy. But these contracts can get complicated, so it is recommended that you do your research and consider retaining a lawyer to review the contract terms before signing.
Maybe you’re still cleaning up a past credit problem that’s keeping you from qualifying for a mortgage. If this is the case, proceed with caution and utilize this time to clear up any credit issues, because you want to be as sure as you can that when the rent period is over, you can qualify for the mortgage and purchase the property without losing any of the money you placed into the option.
It’s considered a good idea to talk with a lender before executing this type of contract in order to confirm the contract is properly written so that the additional funds set aside from the rent to own agreement are eligible to be used towards the down payment and to identify a home loan program you will likely qualify for and that best suits your needs when the lease period ends.
With these rent to own or lease with option to buy contracts, you can either decide on the purchase price upfront or agree that the sale will be contingent upon an appraisal at the time of purchase. It is generally recommended to get an appraisal and home inspection upfront before entering into a contract.
The appraisal can set the market value of the home and can also give a rent schedule showing rents paid in the area for the same type of home. The rent schedule confirms the base rent charged is reasonable before the option to buy lease amount is added on top.
Some Problems with Rent to Own Agreements
Renting to own isn’t new, but it has evolved in the way the contracts work and the landlords who typically offer these types of properties may have changed in recent years. Before the financial crisis of 2007-08 created the biggest disruption to the U.S. housing market since the Great Depression, rent to own properties were usually offered by individual homeowners.
According to the online real estate database Zillow, that business model changed when real estate investors began buying up distressed properties after the crisis and marketed them to tenants with the idea that an additional portion of their monthly payments eventually would go toward a down payment.
That’s a plan that may hold a lot of promise for prospective homeowners who hate the idea of throwing away their money on rent payments. Rent to own listings may also offer an attractive alternative for some to a traditional home purchase for those who do not yet have a down payment saved.
But the rent to own path could have some serious downsides. Before you sign on the dotted line, it’s important to make sure that a rent to own path is right for you. Here are some points to consider:
1. Selection May be Limited
If you have your heart set on a certain neighborhood or home design, you might be out of luck. Unless you can find a seller in your target neighborhood who’s willing to do a rent to own or lease arrangement, you’ll likely have to stick with what’s available through real estate companies who offer these types of contracts. This can seriously limit your selection and might mean you end up in a home that isn’t the right fit for you.
2. You’ll Likely Pay Higher Than Market Value Rent
With these agreements, it’s typical for individuals to pay above market rent amount because part of the payment is going toward what will eventually be considered in the down payment on the home. (For example, you might pay $2,000 to the landlord, and $300 of that will be set aside for your down payment.
If you have a three-year purchase agreement, that will amount to $10,800 paid toward the down payment fund on the house, plus any other money you put down upfront.)
3. You Might Lose the Money you Thought was Going Toward Your Down Payment
Saving for a down payment while paying your rent may sound like a good deal, and sometimes it is. However, you may want to consider that if you eventually choose not to purchase the property, you could lose your deposit or option fee and possibly any other money you have paid toward the option or purchase. Ouch.
4. The Home’s Value May Decrease
We all know how the real estate market cycles through periods of booms and busts. If you sign a rent to own contract, you may have chosen to agree to a purchase price in advance.
You might agree to a certain price if you buy within three years, for example, and then, potentially, a higher price if you buy within five years, and so on.
The price you agreed to pay upfront will likely fluctuate with time and if the value of homes in the neighborhood depreciates during that period, you could be stuck with a purchase price way above the current market value for the house.
You may decide to back out of the buy because the house won’t appraise for the previously set purchase price, but you’ll likely forfeit the money you’ve paid toward the purchase. (See above.) One good idea is to try placing an appraisal contingency within the contract.
5. The Option to Buy Doesn’t Guarantee You’ll Qualify For Financing
If you’re considering a rent to own or lease with option to buy contract because you’re worried
you may not currently qualify for a mortgage, the arrangement might not be as helpful as you think. Although a lease with option to buy contract can get you into a house that you’ll later have the option to purchase, it doesn’t guarantee you’ll automatically qualify for a mortgage on that home when the buy or option is due.
And depending upon your credit profile, you may not be able to count on your timely rent payments as a way to improve your credit profile, however evidence of timely rent payments may be requested by your chosen lender
So you may want to check the contract to make sure the rental company or landlord plans to report your rental payments to the credit bureaus.
6. You Can’t Control What The Landlord Does
If the owner stops making payments and the property goes into foreclosure, you may be out of luck. And you may not have much say if the property isn’t maintained to your standards. (It may seem like a cost-saving measure to sign a contract that requires the tenant to do the upkeep, but the cost of maintaining the home could mean a further loss if you decide not to buy the home.)
Again, these are details that should be clearly outlined in the rent to own or lease with option to buy agreements. And you may wish to have a real estate attorney go over that contract before you sign.
Do These Contracts Compare to Qualifying for A Mortgage?
If you’re serious about becoming a homeowner, a traditional home purchase along with a mortgage may offer a wider array of options. With a traditional mortgage, you take out a loan to cover the purchase price of your new home minus your down payment. A mortgage loan allows you to immediately purchase your home, as opposed to renting first.
Then you make payments to the lender until the home is paid off or you decide to sell and pay what you still owe. If you find you find yourself short on the down payment amount, consider asking a relative for a gift or if you are a first time home buyer, try looking for down payment assistance programs you might be eligible for in your area.
The loan process can be challenging, but if you choose to get pre-approved, you will discover how much house you can truly afford—so there won’t be any surprises or the disappointment of losing a home you can’t qualify to buy after months or years of paying on the option.
And things like appraisals, home inspections, and title checks—although added time and expense—have been put in place to protect the homeowner as well as the lender.
There may also be some tax benefits to owning that you don’t get when you rent. If you have any questions it is recommended you check with your tax advisor. And if you’re the DIY type, renting a house that you can’t renovate or perhaps even decorate to your taste might feel a little stifling.
If you purchase a home, you can dig in and do almost anything you like—and those improvements (new roof, new A/C, new quartz countertops and hardwood floors, new landscaping for curb appeal) could potentially add to the value of your home.
So if you decide after some years to move on, you can sell and perhaps get something back for your efforts. (It’s important to note that if you live in a condo, co-op, or other HOA type property, you may have to get permission to do renovations from your HOA board.)
Finding the right mortgage may help you buy your dream home without being subject to the restrictions and risks of a rent to own type contracts. If your income and credit are solid but you’ve been holding back on buying because you’re worried about coming up with a down payment, you might be surprised at how little some programs allow for a down payment. Of course, the smaller the down payment, the more loan interest you will be financing.
And lenders like SoFi offer several different loan types and loan terms. Pre-qualifying to see what you can potentially borrow is also fairly pain-free and may be accomplished in just minutes online.
If you think you’re ready for homeownership, you may want to take a break from clicking on realty sites and check out what it takes to get approved for a mortgage loan. Then armed with that knowledge, you can decide how much of a commitment you’re really willing to make.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
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