By Justin Pritchard. Banking/Loans Expert
Justin Pritchard helps consumers navigate the world of banking.
Rent to own transactions look and feel a lot like traditional bank loans, and they often come to mind as an alternative to using a home loan. But there are some important distinctions that you should be aware of before you use one of these programs. There are certainly benefits in some situations, but buyers and sellers both take risks.
What Is Rent to Own?
Rent to own is a way to buy or sell something. However, the transaction does not take place immediately. If you think about a standard home purchase, the sale takes place immediately and everybody is done with the transaction at closing. Even if the buyer does not have enough money to pay for the home (which is most of the time) the transaction can be completed because a bank will help the buyer come up with the full purchase amount.
A rent to own transaction is different. The buyer and seller agree to the possibility of a sale at some point in the future.
Ultimately, the renter/buyer decides if the transaction will actually take place. In the meantime, the buyer makes payments to the seller, and a portion of those payments (usually) reduce the money needed to buy the house at a later date.
Why Use Rent to Own?
Rent to own programs can be attractive to both buyers and sellers. For buyers, the benefits include:
- The ability to "buy" with bad (but hopefully improving) credit scores
- The ability to lock in a purchase price, in case home prices rise over the next few years
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- A way to get to know a home and a neighborhood without making a huge purchase
- Access to more potential homebuyers (not everybody has good credit and can qualify for a loan)
- A way to earn income on a property
- The potential for a higher sales price
- A renter/buyer who is invested in the property, and interested in keeping it in good shape
How It Works
A rent to own transaction starts with the contract. Both the buyer and seller agree to certain terms, and all of the terms are negotiable. Depending on what's important to you (whether you're a buyer or seller), you can request certain features before signing the contract. For example, you might request a larger or smaller up-front payment if that would be helpful for you. Be sure to go over any contract with a real estate attorney, as these transactions can be complicated, and there is a lot of money involved. Rent to own transactions are especially risky for buyers; there are plenty of scams that take advantage of people with poor credit and high hopes of buying a home.
At the beginning of any rent to own transaction, the buyer pays the seller an option premium. This is just a payment that gives the buyer the right or “option” (but not the obligation) to buy the home at some point in the future. That payment is non-refundable, but it can be applied to the purchase price (if the buyer ever buys the home, she won't have to come up with as much cash). Option payments might be around 5%, plus or minus a
few percentage points. Higher option payments are risky for buyers: if the deal doesn't go through for whatever reason, there's no way to get that money back.
The buyer and seller set a purchase price for the home in their contract. At some point in the future (usually between one and and five years, depending on negotiations), the buyer can purchase the home for that price – regardless of what the home is actually worth. When setting the price, a price that’s higher than the current price is not uncommon (otherwise, the seller is better off just selling today). If the home has gone up in value faster than expected, things work out in the buyer's favor. If the home loses value, the renter probably won't buy the home (partly because it might not make sense, and partly because the renter might not be able to qualify for a loan with a high loan-to-value ratio ). Buyers usually apply for a mortgage when the time comes to purchase the home.
Of course, the buyer/renter also makes monthly payments to the seller. Those payments serve as rent payments (because the seller still owns the property), but the renter typically pays a little bit extra each month. The extra amount is usually credited to the final purchase price, so it reduces the amount of money the buyer has to come up with when purchasing the home. Again, the extra rent "premium" is nonrefundable – it compensates the seller for waiting around to see what the buyer will do (the seller can’t sell the property to anybody else until the agreement with the renter ends).
Rent to Own Pitfalls
Nothing is perfect, and that includes rent to own programs. These transactions are complicated, and both buyers and sellers can get some unpleasant surprises. A few examples are listed below, but the list of things that can potentially go wrong is much longer. Only a local real estate attorney can give you a good idea of what's at stake in your situation, so be sure to visit with one before you sign anything.
For renters/buyers, some potential problems include:
- If you don't buy the home – for whatever reason – you lose all of the extra money you paid
- You might not qualify for a loan before your option term expires
- You don't yet own the property, and your landlord might lose the property through foreclosure
- Home prices might fall, and you might not be able to renegotiate a lower purchase price
- If you don't pay rent on time, you may lose the right to purchase (along with all of your extra payments)
- There might be problems with the property that you don't know about until you try to buy it (such as title problems )
- Rent to own scams are not uncommon
- Your renter might not buy, so you have to start all over again and find another buyer or renter (but at least you get to keep the extra money)
- You don't get a large lump-sum, which you might need to purchase your next house
- You typically lock in a sales price when you sign a rent to own agreement, but home prices might rise faster than you expected
- Home prices might fall, and if your renter does not buy, you would have been better off simply selling the property