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Would a Rent-to-Own agreement be right for you?

Posted by: George Fry
Date: June 12, 2020

Most people that want to purchase a home will need to get a mortgage to finance the purchase. To qualify for a mortgage, you must have a good credit score and enough cash for the down payment. If you have challenges in either of these areas then you may want to consider a Rent to Own approach to home ownership.

Rent-to-own is also known as a Lease Option or a Lease Purchase. These are legal contracts, where you, the tenant/potential buyer, under the written terms of the contract, have the opportunity to purchase the property you are leasing at a later date.

When talking with clients I have found that many people think that the term rent-to-own means that all of the monthly rent would be applied to the eventual purchase of the home. While this would be a fantastic opportunity for a buyer, it is almost never a great deal for the seller/investor. As with any type of purchase transaction, a rent-to-own agreement will only work if both the seller and the buyer will benefit from the transaction.

So, what kind of terms and conditions might be in a rent-to-own agreement?

In a rent-to-own agreement you commit to renting the property for a specific time period, but have the option to purchase before the end of the lease.
It is important to understand that a lease-option gives you the right to buy, but a lease-purchase will require you to buy.
The purchase price may be preset with incremental increases like 4% per year, or may be determined by an appraisal at the time of purchase.
In some cases, part of the rent may be applied to the purchase price, but in that instance the monthly payment is usually higher than standard rental rates.
Some rent-to-own contracts may require you to maintain the property and pay for repairs.
The seller is responsible for covering taxes and insurance on the property until it is actually sold.
The buyer will still have to meet certain financial qualifications to get the seller’s approval.
The buyer will eventually need to finance the purchase with a mortgage obtained from a lender of their choice.

Here are a few examples of how a rent-to-own agreement might work.

Lease Purchase: In this lease option an investor will buy the home you select, and then lease it back to you for up to 5 years. With this option the buyer is not obligated to purchase the home and there is no penalty for not completing the purchase. There are no upfront costs for the potential buyer beyond the standard first month rent and security deposit. During the 5-year period the buyer has the exclusive right to purchase the home at any time, at a preset price. The lease is in one-year increments and the monthly payment will increase yearly at a preset amount. There are no surprises, and the buyer has the time they need to repair credit or save money for the down payment.

In this situation the potential buyer has a lot of flexibility. You can end the agreement at the end of any one-year lease period. However, the monthly lease is usually above the market rate, and the tenant does not have the right to make any changes to the property until they actually purchase it.

Lease Option: In this lease option, the potential buyer pays the property owner a one-time (usually non-refundable) lease option fee called option money. This fee can range in amount but is often between 2.5% and 7% of the property’s purchase price. The option money is credited toward the purchase price when the transaction closes. The contract specifies a set time period in which the buyer must exercise the option to purchase the property, commonly 1-5 years.

The Pre-Possession agreement: While this is similar to a lease purchase, it is not a lease and is not covered by the Landlord Tenant Act.

When entering into a pre-possession agreement, the buyer will actually sign a purchase contract for the home, but the date for closing is set at an agreed upon date in the future. Typically the date would be within 1-5 years.

The buyer pays the seller a nonrefundable pre-possession fee that is credited toward the purchase price at closing. This fee is negotiable, but is commonly 5%. The buyer also pays a monthly pre-possession fee (equivalent to monthly rent) that is not applied to the purchase price. The buyer is also responsible for maintaining the property, at minimum to its current condition, including repairs.

Read: How Does Rent-to-Own Work?

What are the benefits and risks of Rent-to-Own for you?

Benefits

You get to enjoy living in a home that you love for several years while you are improving your credit score or saving for the down payment.
There may be the security of knowing in advance what you will pay for the home, and what your lease costs will be until that occurs.
Option money, and in some cases, part of the rent will go toward the down payment.
The purchase price of the home may be below market value at the time of purchase, so there may be an opportunity to have built-in equity.
The home can’t be sold to anyone else during the lease option period.
You won’t have to compete with other buyers when you are ready to purchase.

Risks

If you are not able to purchase at the end of the lease option period, most or all of the money that was paid to the seller up front will be forfeited to the seller, and your option to purchase is lost.
There may be other stipulations in the contract that put some or all of the option money, or your right to purchase, at risk.

There are a variety of ways that a rent-to-own agreement can be structured, the details of which are specified during the negotiation process. In fact, there are far too many variables to adequately explain all of them in this brief overview.

Therefore, to protect your interests, it is always advisable to obtain the services of a real estate professional, or seek legal advice from a real estate attorney, before entering into any legally binding contract.