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How does rent to own work?

Rent-to-own can be a great alternative if you can't afford to buy a home outright, have a low credit score or don't have enough money for a down payment. Rent-to-own contracts can also give you the chance to see how you like a home and neighborhood without committing to buying it. Read on to better understand what rent-to-own means, how the process works and what you should know if you're interested.

What does rent-to-own mean?

Simply put, rent-to-own is where you rent a home for a certain period of time before you buy it. Depending on the terms of the contract, that period can range from several months to several years. These contracts are different than a traditional renter's lease or purchase contract.

As part of your rent-to-own contract, the seller agrees to put a certain amount of money from your monthly rent payment toward your equity in the home.

There are two kinds of rent-to-own contracts: lease-purchase and lease option. With a lease option contract, you have the option to purchase the home after a time period you and the property owner have agreed upon. With a lease-purchase contract, you're legally obligated to buy the home at the end of that period.

The rent-to-own basics

There's no one-size-fits-all approach with the rent-to-own process. However, rent-to-own transactions typically have several standard components, including:

  • Purchase price: A rent-to-own contract typically specifies the home's purchase price. In some cases, the purchase price won't be determined until the lease expires.
  • Rent payments: The contract will specify the amount of rent you’ll pay each month. Rent prices in a rent-to-own contract are usually higher than regular rental fees since the owner sets aside a portion of your monthly payment for use towards your future purchase of the home.
  • Maintenance: The contract notes who is responsible for covering maintenance—you or the property owner. Make sure you understand what you're agreeing to repair if maintenance is necessary.
  • Option fee: As part of a rent-to-own contract, you may be required to pay a one-time, non-refundable fee. This fee is usually a percentage of the purchase price, although there is no standard amount.
  • Lease term: The contract will also specify the terms of the lease and how long you'll be renting before moving forward with a purchase.
  • Closing process: You'll need to obtain financing at the end of the lease if you want to purchase the home. The money set aside from your rent payments may be credited to you at this point. Lenders may have guidelines that limit how much can actually be credited, such as only permitting the amount you can document was paid above market rent.

Advantages and disadvantages of rent-to-own contracts

Rent-to-own listings aren’t as common as sale or rental listings. Usually, rent-to-own happens under specific circumstances, such as:

  • The property owner is having trouble selling the home.
  • The renter already lives there and is happy with the property, but the landlord wants to sell.
  • The home has been on the market for some time, and a prospective buyer approaches the seller with a rent-to-own offer.

Rent-to-own contracts aren't for everyone. It's important to be aware of the advantages and disadvantages before entering into one:

Advantages

The advantages of this type of contract include:

  • Building a down payment over time: Rather than having to save up the cash for a down payment, you may be able to build equity in the home by paying higher rent over one or multiple years.
  • Avoiding competition: By signing a rent-to-own contract, you know you'll have the option to purchase the home at the end of the lease so you won’t have to compete with other buyers.
  • You don't have to qualify for a mortgage immediately: If you need to improve your credit score or pay off debt before you can save up for a down payment, a rent-to-own contract can be a great solution. It helps you secure the home you want while giving you more time before you need to look for financing.

Disadvantages

Possible disadvantages of a rent-to-own contract include:

  • The option is nonrefundable: To have the option to purchase the home at the end of your lease, you may need to pay a percentage of the home's purchase price upfront. If you decide not to purchase, you likely won't get this money back.
  • Paying for maintenance: You might find yourself responsible for repairs for a home you don't yet own. In the event of an emergency, you could be out hundreds, even thousands, of dollars.
  • Home value drops: If you have a rent-to-own contract where your lease is for an extended period of time, there's no way to know what the housing market will do during that time. If the purchase price reflected inflated prices when the contract was created, you could end up paying more for your home than it's worth when it's time to buy. Consider adding a contingency clause that the appraised value must be at least the amount of the agreed upon sales price.
  • You could change your mind: Situations change. Your job might require you to relocate to a new area, or you may find that you can’t qualify for the mortgage you need to buy the house. As long as you have a lease option, you can walk away. However, you might lose thousands of dollars in higher rent payments that you cannot recover.

In some cases, you might be better off renting. As a renter, you can spend time saving money or working to build your credit before purchasing a home.

The rent-to-own process

Once a seller has agreed to a rent-to-own contract, the steps you’ll take include:

  1. Sign a rent-to-own contract: Since there are two kinds of rent-to-own contracts, it's important you understand what you're agreeing to. Watch out for lease-to-purchase contracts, as you may be legally obligated to purchase the home at the end of your lease, whether you can afford it or not.
  2. Agree to a purchase price: You can get a general idea of local market prices by looking at similar listings in the neighborhood or nearby neighborhoods.
  3. Determine the rental term's length: Typically, the rental contract lasts between one and three years. Consider where you are financially and how long it will take you to be ready to qualify for a mortgage. If your credit score isn't where it needs to be to qualify for a good interest rate, you might want to consider a longer rental period to improve your credit.
  4. Define maintenance roles: Each rent-to-own contract is unique, so it's important to get in writing what you'll be responsible for as the renter. For example, are you responsible for only what's inside the home, such as appliances and other repairs, or are you also responsible for lawn maintenance and the AC unit?
  5. Rent payments: With a rent-to-own contract, the rent is usually higher than it would be in a normal renting situation. You might be able to negotiate the amount you pay, although it's important to get in writing exactly how much of your payment will go toward your property purchase.
  6. Shop for a mortgage lender: As the rental term for the property nears an end, you'll want to shop around for a mortgage as you would with any other home purchase.
  7. Keep Records: Retain copies of checks/bank statements or other documentation to prove what you have actually paid. This documentation may be required by your lender.

A rent-to-own contract allows potential homebuyers to move into a home right away while they save for a down payment or improve their credit score. That said, there are a number of factors to consider before you agree to this type of contract. Always make sure you understand the terms of your contract before you move forward with one.