Working in real estate I sometimes get asked about Rent-To-Own programs, how they work and if they’re a good deal. Because let’s admit it, it sounds awesome. But rent-to-own financing is very risky both for the buyer and the seller. It’s best to have either a REALTOR or a real estate attorney represent you in these transactions.
How They Work
Rent-to-Own financing is an option for buyers that do not have the minimum credit score required by a bank to obtain conventional financing. Rent-to-Own is also sometimes called a rental-purchase. It is a standard lease with the option to purchase the home at a set price over a specific period of time – usually 2-3 years. This agreement requires the buyer to make a one-time down payment of usually 2.5% to 7% of the purchase price. The down payment is NON REFUNDABLE. Typically the entire down payment is applied towards the purchase price of the home at closing. For example, if you are buying a $150,000 house you would need to put down between $3,750 and $10,500.
In addition to the down payment, a portion of the monthly rent will be applied to the principle of the loan. But here’s what no one tells you – your monthly rent will be whatever the landlord could rent the house for in the current market and the portion of the rent that goes toward the principle is put ON TOP of the standard rent. So if the landlord can rent the house for $1,300 a month, s/he might charge you $1,450 and the $150/month will accrue and be used toward the purchase of the home at closing. If you are in a three year agreement, you’ll have paid $5,400 in monthly rent that will be applied to the cost of the house. At this point in time you’ll have between $9,150 and $15,900 in equity in the home (down payment of 2.5% – 7% plus $5,400 in rent credit).
Terms of the Agreement
Be careful here – these agreements are not like a typical lease. If you are late with your rent payment, you may not get any credit of that payment towards the purchase price. Also, you may be responsible for all of the maintenance of the home – you will be living there just like a homeowner and may need to assume the financial responsibility if the heating system fails or water heater stops working. Below are typical terms and conditions one might expect to find in a contract.
- In order to receive a rent credit of 50%, time is of the essence. You MUST pay your rent on or BEFORE the due date of your lease (typically the 1st of the month). This means it must be received by the lessor (landlord) on or before the due date. Any payment received after the due date will result in a 0% rent credit for that month, a late fee may apply and you will not be building any equity.
- Maintenance is the responsibility of the Tenant Buyer. You are now renting to own and home ownership requires maintenance. This includes things like broken windows from stones or baseballs, clogged drains, peeling paint, broken appliances, burnt out bulbs, lawn work/snow removal, etc. If any major repairs are required to ensure habitability, the owner remains responsible.
- You need to have Option Consideration. Option Consideration is typically 2.5% to 7% of the purchase price of the home. It is a non-refundable payment, of which 100% is credited toward the purchase price, which binds the lease purchase contract.
The BIGGEST Secret
So far this is probably sounding really awesome and you’re wondering why there are not more rent-to-own homes available! That’s because until you close on the home you don’t own it. Not any of it. All of that equity you built up over three years? It will be GONE if you can’t acquire a loan to purchase the home at the end of the agreement. Rent-to-own agreements appeal to buyers that have poor credit scores and cannot get conventional financing from a lender. What a rent-to-own gives you is a three year period in which you can build equity and fix your credit so you can purchase the home at the end of the agreement. Unfortunately, most people are not able to get their credit to an acceptable level by the time the agreement ends and end up losing all of their equity.
For example: You sign a 3-year rent-to-own agreement, 2.5% down on an agreed to purchase price of $150,000 and monthly rent of $1,450 with $150 of it being rent credit. Market rent is $1,300/month with no rent-to-own option.
Total paid for down payment and monthly rent at the end of three years = $55,950.
Total cost to rent at market rate over three years= $46,800
Are you willing to bet $9,150 that you can get your credit score fixed in three years?
Did you treat this like a lease or a purchase?
When entering into a rent-to-own agreement, most buyers treat the transaction like a lease instead of like a purchase. They review the paper work and might even have an attorney review it but they neglect to conduct a home inspection, pest inspection, radon test or ask for an estimate of what closing costs could be BEFORE signing the contract. Ordering an appraisal is also a good idea so you are sure you’re not overpaying for the home. After living in the home you may find deficiencies that would have deterred you from purchasing it. Also, you might be very surprised to learn how much closing costs are. Between lender fees, title insurance and transfer tax closing costs on a $150,000 house could be over $5,000.
I strongly recommend that you meet with a lender at the beginning of this process and get an estimate of how long it will take you to get your credit to an acceptable minimum level. If it’s more than 3-years, a rent-to-own is not a good financial decision.
Because Rent-to-Own real estate contracts are flexible documents, there is room for scammers to take advantage of unprepared tenants. Rent-to-Own proponents recommend consulting a licensed REALTOR and/or a real estate attorney for every step throughout your transaction for your safety.