Understanding “Rent-to-Own” Agreements: Advice for Buyers

The rent-to-own story can sound like a sweet one when the economy itself, and real estate with it, becomes difficult. Suppose you’re the seller: You’ve already signed on the dotted line for a new home, but your current home has yet to sell. If you can’t afford to just let your home sit, and you’re trying to make the purchase of this home more attractive, you might consider offering a rent-to-own option.  Then you at least enjoy rental income– especially important if you’re carrying two mortgages.

But rent-to-own (or “lease-to-own) agreements are incredibly complex, offering pros and cons to both seller and buyer. And since this week’s blog theme is “rent or buy,” we concentrate here on rent-to-own from the buyer’s perspective, with the caveat that sellers should be equally cautious before entering such a contract.

The Process

As a buyer for a lease-to-own home, you start as a tenant. This seems frustrating if you’re trying to make the move from rent to own, but the payment system is different than in a traditional rent situation. Here, you pay a certain amount each month to live in the house until the end of an agreed period of time, at which point you have the option to buy the house. During that period of time, you pay rent, but a portion of your rent is set aside as potential down payment for the house, should you decide to buy it.

On the plus side, potential homebuyers who need some help making the jump from renter to buyer can use “rent-to-own” to get their feet in the door—literally and figuratively—of their own homes. But there negative aspects too you must understand. Here are the pros and cons of rent-to-own agreements, for buyers.

PRO

  • You have time to build income as you rent, which can be used for down payment.
  • You have time to repair credit, also important for later home buying.
  • If something is really wrong with the house, you can usually walk away, just as in a traditional home lease.
  • This option is cheaper, to get you in the door, than a traditional 20% down payment.

CON

  • If you walk away, you lose the “option fee,” which means you lose all the money set aside in your monthly payments towards buying.
  • There is usually an upfront option fee, some percentage of the agreed-upon selling price of the home which you and the seller negotiate before you move in. This payment can be quite high- less than a down payment for a house, yes, but still hard to scrape together.
  •  Realize this contract is strict: If you are even one day late paying rent, you could lose your lease option and with it, the lease option money you have thus saved.
  • You don’t own the house; the seller does. So, if the seller fails to pay the original mortgage on the house, you may find yourself looking for a new place to live when the home is foreclosed—and again could lose all saved lease option money.
  • In most cases, you have to make repairs, though you are not the owner. Right: You do home maintenance or call someone to do it, and pay for all of it. In this way the agreement trains you to be a homeowner, but the added expense is never welcome.

Alternatives to Rent-to-Own Contracts

These days, with financing becoming so challenging,  sellers and buyers are reaching new agreements that allow for creative ways to transfer ownership, and given the difficulties renting-to-own can present, these are worth exploring.

  • Wraparound Financing

Sarah Siddons and Chris Opfer of The Discovery Company’s “How Stuff Works” explain this process as follows:

“[When] the seller has a mortgage on the home and the buyer has sufficient income but, for a variety of reasons, is unable to obtain a mortgage, the buyer makes a down payment at the time of the sale and signs a promissory note to the seller for the remainder of the purchase price, plus interest. The buyer then makes monthly payments to the seller, who uses that money to pay off the existing mortgage.”

  •  Owner Carry

Buying a home under “Owner Carry” terms means the current property owner finances part ,or all, of the sale. This is usually accomplished through a second mortgage, although sometimes the owner will carry the entire loan. This helps both seller and buyer. 1) The seller can ensure the transaction moves quickly and successfully (unlike with banks, sometimes!) and can use the agreement to pay the least amount of capital gains possible. 2) The buyer gets a financial boost without having to qualify for today’s more stringent loans, and  avoids potentially overwhelming costs associated with conventional loans.

  • Invest on Your Own

Rather than investing in the down payment of a lease-to-own home through a portion of your rent, you could just continue to rent and put money aside each month, whether into a savings account or CD. Then, your money is safely waiting for you, whenever you are ready to buy. And, though the interest on savings these says is modest, your investment is at least growing a little while you wait—not usually the case in rent-to-own arrangements.

  • Rent or Own?

For more on deciding if you are ready to make the move from renting to owning, check out ZipCode’s blog on this question, as well as ZipRealty’s Learning Center.