Rent-To-Own Homes: How It Works And What To Consider

Interested in buying a house but struggling to come up with enough funds to cover your down payment or closing costs? Maybe your credit score or income is too low to qualify for a mortgage. You might consider a rent-to-own home, which gives you the chance to live in a single-family home with the goal of eventually buying it.

But is a rent-to-own home the right choice for you? Read on to learn about the pros and cons of renting to own and how these real estate deals work.

What Is A Rent-To-Own Home?

A rent-to-own home is a residence that you rent for a set period. Unlike in a typical rental agreement, though, you have the option to purchase the property before the lease expires.

Your rent-to-own agreement will spell out how long you can rent the home before you must decide whether you buy it. Your agreement might also require that you pay an upfront option fee to the home’s owner. This fee, which is typically 2% – 7% of the home’s value, locks in your option to buy the home and can later be used to reduce the purchase price if you decide to move forward with the purchase.

Say you pay $5,000 as an option fee and you and the owner agree on a $250,000 sales price for the home you are renting. You can apply the $5,000 option fee you’ve already paid to reduce the sales price to $245,000.

How Does Rent-To-Own Work?

Some rent-to-own agreements will specify that a certain portion of your monthly rent is saved in an escrow account. You can later use this extra money, known as rent credits or rent premiums, to help cover a down payment when you buy the house.

Rent-to-own agreements do come with risks, though. If you decide not to purchase the home, you’ll typically lose the money set aside in this escrow account. You’ll usually lose any option fee that you pay, too.

If your option fee is 2% – 7% of the home’s value and the property you are renting is valued at $250,000, you could lose $5,000 to $17,500 if you don’t purchase the home at the end of your lease.

Types Of Rent-To-Own Agreements

There are two main types of rent-to-own agreements, lease-option and lease-purchase.

Under both options, you can lease a home for a specified time, often 1 – 3 years. You’ll then have the option to buy the home as your lease ends. One option, though, comes with more flexibility.

Lease-Option

Under the lease-option arrangement, you agree to rent a home for a set period. You’ll typically pay an option fee of 2% – 7% of the home’s value and pay a bit extra each month in rent. Those extra rent payments, again, will be deposited in an escrow account that you can later tap to cover a down payment.

You and the home’s owner might agree on a sales price for the home when you initially sign your lease-option agreement. This is the price you will pay at the end of your lease-option, even if the value of the home rises or falls during the agreement.

At the end of your lease, you have the option to buy the home. You are not required to do so, though. You can walk away from the purchase. If you do, you’ll usually lose both the extra you paid each month in rent and your option fee.

Lease-Purchase

A lease-purchase agreement provides less flexibility because it requires both the seller to sell the home and you to buy the home at the end of your lease period. This differs from a lease-option agreement that only requires the seller to offer the home for sale at the end of the leasing period.

In other ways, a lease-purchase agreement works similarly to a lease-option arrangement. You’ll again agree to lease the home for a certain number of years while paying extra rent credits each month. Again, these credits are saved in an escrow account that you can later tap to help cover your down payment.

The lease-purchase contract will typically state the price that the home will sell for at the end of the lease agreement. Renters will also typically pay rents that are higher than market value. You might not be required to pay an option fee in this type of arrangement.

If you decide not to buy the home after the lease ends, you will be in violation of your contract. The homeowner, then, could sue you for breach of contract. You’ll also lose the extra rent you’ve paid. This is true even if you try to purchase the home but can’t because you don’t qualify for mortgage financing.

Rent-To-Own Homes: Pros And Cons

As with all home buying arrangements, there are both pros and cons involved in entering into a rent-to-own agreement.

Pros

• You can lock in your sales price: With some rent-to-own agreements, you and the owner of the home agree on a sales price early, when you sign your lease agreement. If the home’s value rises throughout your lease, you might end up paying less than market value for the home.
• You can save for a down payment: In most rent-to-own agreements, you’ll pay a higher rent each month. This extra money is saved as a rent credit. When it’s time, you can use this extra money to help cover the down payment on the purchase of the home.
• You can buy time to improve your credit: You might enter a rent-to-own arrangement if your credit score is too low for you to qualify for a mortgage. While renting the home, you can take steps to improve your credit score, such as making your monthly payments on time and paying down your credit card balances. When the lease period ends, your score might be high enough that you will qualify for a mortgage.
• You can save on moving costs: If you rent a home and then buy that same residence? You won’t have to move from one home to another, which can save you a significant amount of money in moving costs.

Cons

• You could lose money: If you don’t decide to purchase the home after your lease period ends, you could lose your option fee and the extra money you paid each month for your future down payment.
• You might overspend: In some rent-to-own agreements, you and the home’s owner decide on a purchase price at the beginning of your lease period. If the home’s value declines while you are leasing, you might end up paying more for the home than its current value when it’s time to buy.
• You will have to pay fees: You’ll often pay both a lease option fee and higher monthly rents during a rent-to-own agreement.
• You might be responsible for maintenance and upkeep of the home: When you rent an apartment, it’s your landlord’s responsibility to keep the lawn mowed and repair leaking pipes or fix broken windows. In a rent-to-own agreement, these responsibilities might fall onto you depending on the terms of your lease.

How To Buy A Rent-To-Own Home

How do you find and buy a rent-to-own home? Here are the key steps:

1. Determine Your Budget

You’ll first need to create a household budget listing your monthly expenses and revenue. Be sure to include expenses that vary, such as groceries, healthcare costs and monthly utility bills. Also include discretionary spending, such as the money you spend on eating out or entertainment. Once you have a budget listing the money coming into and out of your household each month, you can determine how much you can afford to pay in monthly rent and upfront fees. You can also determine how much you can afford to spend on a monthly mortgage payment once you purchase the home.

2. Find A Rent-To-Own Home

But how do you find a rent-to-own home? That can be tricky. Your best bet is to work with a real estate agent who can help you find these properties in the neighborhoods in which you want to buy. You can also search online for rent-to-own portals that list these properties.

3. Negotiate The Terms

Before signing any rent-to-own agreement, you’ll need to negotiate everything from your monthly rent to the size of your option fee to whether you are entering into a lease-option or lease-purchase agreement. You’ll also negotiate the eventual purchase price of your home, either settling on a price that remains fixed throughout your lease period or one that might rise or fall depending on home values when you are ready to buy.

4. Review The Agreement

After you and the seller agree on the terms of your deal, make sure to review the rent-to-own agreement. Look for key items such as your monthly rent, the length of the lease period and the price of the home once you’re ready to buy. Make sure these terms are identical to the ones upon which you and the seller agreed. Consider hiring a real estate attorney who can also look over the agreement.

5. Pay The Option Fee And Pay Rent

If you enter into a lease-option agreement, you’ll pay your option fee upfront. You should have negotiated this fee, which varies by transaction, before signing your rent-to-own agreement. Once you sign the agreement, you’ll start paying your monthly rent as you would with any rental.

6. Apply For A Mortgage

As your lease period is nearing its end, it’s time to apply for a mortgage to finance the purchase of the home. Your lender will check your credit reports and credit score and verify your income and debts. If you need advice about the mortgage-lending and home-buying process, check out our home buying checklist.

Is Rent-To-Own A Good Idea?

Should you consider a rent-to-own arrangement? That depends largely on your financial situation.

Maybe you don’t have enough money saved to cover a down payment on a home. By entering into a rent-to-own agreement, you could buy yourself one to three extra years to save enough for that down payment all while securing a home that you want to buy.

Rent-to-own could be a good option if your credit score is so low that you either can’t qualify for a mortgage or you can only qualify for one with high interest rates. You can take the steps necessary to improve your credit score while leasing the home you’ll eventually buy.

But if you already have enough money saved for a down payment and your credit score is strong, a rent-to-own arrangement probably doesn’t make sense.

The Bottom Line

If you’re ready to buy a home, a rent-to-own arrangement could get you closer to your goal. Just make sure to read the fine print of your leasing agreement so that you’re not overpaying for your eventual home. And if your rent-to-own agreement is nearing its end? You can start the mortgage approval process with Rocket Mortgage® today.