Everything You Need To Know About How Rent-To-Own Works

Buying and renting both come with advantages and disadvantages.

Buying a house lets you build home equity, but it also – at least in many cases – requires you to save enough money for a down payment, closing costs and repairs. Renting may not involve as many costs or require saving as much money, but it doesn’t help you build equity.

If you’re torn between buying and renting, a rent-to-own home is one option that might be worth exploring. Rent-to-own homes seem to promise the best of both renting and buying, but is rent-to-own really a good idea? Let’s delve into what a rent-to-own home is exactly and how it works.

A rent-to-own agreement allows you to buy a home after renting for a period of time. You may pay a bit more in rent than the home’s fair market value, but the extra money becomes your down payment at the end of the lease.

Depending on the terms of your agreement, you may need to pay an “option fee,” also called “option money,” to lock in the option of buying the house. You usually have to pay this fee to the seller upfront, and it’s often nonrefundable.

If you don’t buy the property at the end of the lease, you typically lose the money you spent on this fee, and you also lose any extra money you’ve poured into the rent.

When you rent-to-own, you rent a property with the intention of buying it when the lease ends. Typically, a portion of the monthly rent you pay to the homeowner goes toward a down payment on the home. You have the option to use the accrued money, sometimes called rent credit, to buy the home at the end of your lease term.

Keep in mind that this rent credit is often limited to the most recent 12 months of rent and may be subject to additional loan program requirements depending on loan type.

Two major types of rent-to-own agreements are typically available: lease option and lease purchase.

Both contracts allow you to lease a home for 1 – 3 years and then buy it at the end of the term. However, the two agreements have some contractual differences you should know about.

Lease Option Agreement

A lease option agreement requires you to pay the homeowner an option fee when you sign. The fee is typically 2% – 7% of the home’s value.

The rent credits you save during the lease term go toward your down payment if you buy the home. In most cases, your option fee will also reduce the property’s purchase price.

You’ll negotiate the home’s purchase price with the seller and use an appraisal to determine how much the home is worth. You can let the agreement expire if you no longer want to buy the property, but you’ll likely lose your option fee and your rent credits.

Lease Purchase Agreement

A lease purchase agreement works similar to a lease option agreement. You lease a home for a few years, and a certain percentage of your rent is set aside and put toward your down payment to buy the home.

However, when you enter a lease purchase agreement, you’re obligated to buy the home at the end of the lease.

You and the seller agree to a purchase price when you sign the lease. Setting a price beforehand gives you a better idea of how much you’ll need to borrow for a loan. If you choose a lease purchase agreement, you should start loan shopping while living in the home or as soon as you agree on a price.

You lose your exclusive claim to the home and all the rent credit you’ve accumulated if you can’t get funding by the end of the lease term. The homeowner can also sue you for breach of contract if you don’t buy the home.

Lease Option Vs. Lease Purchase

Should you choose a lease option or a lease purchase agreement? The answer depends on your financial situation.

A lease option agreement allows you to opt out of buying the home after the lease expires. But a lease purchase agreement requires you and the homeowner to commit to a sale at the end of the lease term. However, if the agreed-upon price doesn’t match market conditions when you intend to complete the purchase, you’ll need to renegotiate the sales price.

Talk with a local real estate agent before making a decision.

Before you settle on whether rent-to-own is right for you, be sure to weigh some of its potential benefits and drawbacks.

Pros Of Rent-To-Own Homes

Here are some of the advantages of a rent-to-own home:

• It lets you save money for a down payment. You can pay toward a down payment while test-driving a home, so to speak, to make sure you like it. The percentage of your rent that goes toward the down payment depends on your contract. Since your monthly lease amount is often higher than the fair market value, the extra money goes toward the down payment.
• You can save on repair costs. Some agreements split the responsibility for repairs between the tenant and the landlord. You may agree to cover the costs of small repairs while your landlord agrees to cover large repairs. This can be beneficial if you need more time to save money to cover large repair bills.
• It offers you time to improve your credit. If you have a brief or weak credit history, you can work on building or repairing your credit while renting. This can improve your odds of approval for a mortgage with ideal terms when it comes time to buy.

Cons Of Rent-To-Own Homes

Here are some potential drawbacks of a rent-to-own property:

• You may lose money if you choose not to buy. If you don’t buy the home, you essentially forfeit any money you paid in rent to the homeowner, plus the option fee if you paid one.
• You may not be able to use or receive full rent credit. Rent credit usually only applies to the previous 12 months. If you rent for a longer period, you may have to negotiate to get the total amount you’ve paid credited toward the price of the home. Rent credit also depends on an appraiser’s opinion of the market rent when you apply for a mortgage. If the current market rent is higher than your monthly rent, the rent credit isn’t usable.
• You likely won’t be able to buy the home if you can’t qualify for a home loan. You all but give up your right to purchase the property if you can’t get approved for a mortgage loan. In that scenario, the homeowner can rent the home again or sell it. Make sure you’re ready to buy the home at the end of your lease and that you’ll qualify for a home loan.

Are you considering a rent-to-own lease? Here are a few situations where rent-to-own can be a good idea:

• You need time to improve your credit score. Your credit score influences mortgage loan terms such as your interest rate. A rent-to-own property can give you the time you need to improve your score.
• You need time to save for a down payment. A rent-to-own deal gives you more time to save up a down payment.
• You don’t think you can save on your own. Having your monthly rent payments go directly toward a future down payment can help you save since the savings are built into your monthly living expenses.
• You know where you want to live. Rent-to-own leases work best when you know exactly where you want to live. When you sign a rent-to-own lease, you should feel confident you want to live in a particular area.

Rent-to-own leases aren’t right for everyone and every situation. These are some situations where you may not want to choose a rent-to-own lease:

• You aren’t sure you can get a loan. You may want to continue renting if you aren’t sure you can get approved for a loan at the end of your lease. Negative marks on your credit report can result in your mortgage application being denied.
• You don’t have a plan to raise your credit score. If a low credit score stops you from getting a mortgage, a rent-to-own lease can give you more time to raise your score. But you won’t benefit from the extra time if you don’t work to improve your credit score.
• You’re frequently late on rent. Some rent-to-own leases stipulate you’ll lose your rent credit if your rent payment is late, even by a day or two. To avoid late payments, consider saving a few months’ rent before signing a rent-to-own lease. If you’re unsure of your ability to pay your rent on time, you may face the same issue with mortgage payments.
• You aren’t sure where you want to live. If you aren’t confident you like the home or the area it’s in, signing a rent-to-own lease may not be beneficial.

Now let’s break down the steps involved in purchasing a rent-to-own house.

1. Find A Rent-To-Own Home

The first step toward entering a rent-to-own agreement is researching how to find rent-to-own homes. You may be able to use an online rent-to-own platform to locate available rent-to-own properties in your desired area.

2. Agree On A Purchase Price

Negotiate the purchase price before signing the lease agreement. The price may be fixed or updated based on market conditions when the agreement expires.

3. Review And Sign The Agreement

Before signing the contract, carefully read the lease terms and conditions. Pay attention to details such as the rental period length, the monthly rent and any repairs or maintenance responsibilities. Knowing this upfront can help save you and the seller from headaches later on.

4. Pay The Option Fee

If you go with a lease option agreement, you’ll pay the option fee when you sign the contract. As mentioned, you can typically expect to pay 2% – 7% of the home’s purchase price.

5. Make Rent Payments

Once you reach an agreement, you start making monthly rent payments.

6. Apply For A Mortgage

Depending on your agreement, you can either buy the property or move out when the rental period ends. If you decide to buy the home, you can begin the traditional mortgage application process to secure financing (unless you have enough cash on hand to buy with a mortgage).

Keep in mind: You’re legally obligated to purchase the home if you sign a lease purchase agreement.

If your financial situation is holding you back from homeownership, a rent-to-own lease can help you progress toward buying a home.

The key, though, is having a purchase plan in place before you sign a rent-to-own agreement. This will allow you to minimize the risk of wasting time and money.

Ready to take the first or next steps in your home-buying journey? Start an application online with Rocket Mortgage^® and seamlessly transition from renter to homeowner.