Rent-to-Own Home Leases
by Nick Gromicko
A rent-to-own agreement, also known as a lease to purchase and a lease option, is a real estate agreement that is a combination of a rental lease and a purchase contract where the tenant has the option to purchase the rental property at a fixed price by a specified point in time of the tenancy. It is designed to give the prospective buyer time to repair credit and save up cash, while the seller gets an opportunity to eventually sell the rental house while earning additional monthly rental income.
During the option period, which is typically less than three years, the prospective buyer lives in the house and pays rent, a portion of which goes toward the down payment. For example, if the home’s rent is $1,000 per month, the owner might charge $1,200 per month and credit the renter with $200 per month toward the down payment, an amount known as the rent premium. Added to an upfront “option fee” of, perhaps, $5,000, the renter will have contributed a total of $7,400 to their down payment by the end of the first year. If the renter decides not to purchase the house, they will lose the rent, the rent premium and the option fee to the seller, who will then search for a new tenant.
From the Seller’s Perspective
Sellers benefit from rent-to-own agreements because it releases them from the burden of selling their old home when unfavorable market conditions prohibit an ordinary sale. And, unlike the buyer, the seller assumes little risk because, even if the home doesn’t sell, they pocket the rent premium and option fee from their former tenant and retain the opportunity to sell the home in the future.
A rent-to-own situation requires patience on the seller’s part, but if they can afford to wait while the renter builds credit and funds to make such a large purchase, the market for their home will be greatly expanded. And renters who plan to eventually own the home are more motivated to perform required maintenance and treat the home better than renters who plan to vacate in a year.
Still, the seller is forced to abide by the contract even if the house becomes more valuable and a new buyer offers to purchase the house at a higher price, unless stated otherwise in the contract with the tenant. Also, sellers strapped for cash who only want to be rid of their old home will take little comfort in the proceeds provided by a tenant who decides to walk at the last minute.
From the Buyer’s Perspective
A rent-to-own agreement is a valuable alternative for prospective buyers who need time to build funds, repair their credit, or are otherwise not immediately ready to make a large purchase. And, unlike sellers, they are free to pursue a different real estate transaction if house prices go down.
Also, renting for several years will give them time to get a sense of whether they enjoy the neighborhood and the house. If anything is found to be seriously wrong with the property, the buyer can opt out of the agreement. Still, a home inspection performed by an InterNACHI inspector is advisable so the buyer can promptly be made aware of any hidden defects before closing the deal.
Strategies for Renters
- Renters should obtain renters insurance, as they are not yet homeowners and ineligible for homeowners insurance, and their personal possessions are likely not covered by the owner's policy on the property.
- Negotiate. A rent-to-own contract is open to adjustments just like any conventional real estate contract. Prospective buyers should realize that they don’t need to accept fees and terms offered “as is” by the seller. The buyer might, for instance, be able to get 50% or more of their rent payments to count toward their down payment.
- Hire an attorney. For a transaction this important, first-time home buyers cannot get enough assistance. A competent attorney should be able to read the contract, explain it to the renter, and make sure they don’t get taken advantage of. An attorney can also write a contract if the standard form isn’t sufficient, although this service may be costly.
- Renters should do their homework. Very often, home buyers in a rent-to-own situation are so excited that they are moving into a house without the hassle of a traditional real estate transaction, including having all the funding in place, that they don’t get the house appraised for its fair market value or inspected by an InterNACHI inspector for problems and defects.
Also, consider that most renters are often less savvy than landlords, who better understand how difficult it can be to obtain a home loan. Rental owners might enter into a rent-to-own agreement knowing that their renter will never be able to obtain a sufficient loan to buy the house. Such unscrupulous individuals can use a rent-to-own option merely as a strategy to get higher-than-market rates for their properties.
Sellers also need to watch market conditions to predict whether their house’s value is likely to appreciate so that they don’t lock themselves into selling it to their tenant for less than its market value.
- Renters who truly believe they will eventually purchase the house should try to extend their option period so that they have more time to build up savings, repair credit, and prepare for a large purchase. On the other hand, renters who eventually opt out of the lease-option agreement will feel the sting even worse if their option period was especially long. Sellers usually negotiate for a shorter option period so that they receive the funds for the house sooner.
- Renters should pay their rent on time each month. Being just one day late on a month's rent payment can void the rent credit for that month under most lease-option agreements. This is actually a blessing in disguise, as late payments are frowned upon by lenders, and a home loan will generally cost more for home buyers whose payment history is sketchy. Penalties for late payments are less forgiving in rent-to-own contracts than in conventional rental agreements.
- Beware of bank foreclosures. If the owner defaults on their loan payments, the bank can foreclose on the home and forcibly remove any tenants, regardless of their agreement with the owner. Depending on the rent-to-own contract, the renter might lose the entirety of their payments and have to go after the former rental owner in court.
In summary, rent-to-own agreements provide a prospective buyer with a guarantee that they may purchase a property at a set price after a proscribed period of time of living in the property and paying rent. Both owner and tenant should be aware of the risks inherent in such an agreement.