If you’re looking to buy a house but your credit has taken a beating, you may want to consider a rent-to-own home.
It’s exactly what it sounds like. A rent-to-own property is a house that you start off renting, with the option to buy it later. It’s a two-step process. First, you rent a house with a lease agreement for a period of time, with some of your monthly payment going toward an eventual down payment. Once the lease expires, you’ll have the option to purchase the property.
This is a strategy you might try in hopes that after several years of paying rent and saving for a down payment, a mortgage lender will find you a better credit risk.
Still, if you’re contemplating going through the rent-to-own process, you’ll want to tread carefully. There are a variety of pitfalls associated with rent-to-own agreements.
Here’s a primer on how rent-to-own deals work and potential risks to be wary of before you commit.
[Read: How Much Rent Can I Afford?]
How Does a Rent-to-Own Arrangement Work?
In a rent-to-own contract, individual homeowners typically enter an agreement with a real estate company for three years, with the option to extend a lease contract for four additional years. After those three years (or seven if you extend the contract), you wouldn’t be making rent payments to your landlord but making payments to a mortgage lender.
A rent-to-own contract will include a lot of numbers, like your rent payment, the length of your lease, the time you have to buy the home, how much you will pay for the home when you’ve made the last rent payment and when you’ve made the last mortgage payment, potential rent credits and an option fee.
The option fee is often between 2.5% and 7% of the purchase price of the home and is required before you move in (it’s sometimes referred to as option money or option consideration). It’s generally nonrefundable.
A rent credit is extra money you pay on top of the monthly rent. That extra money goes toward your eventual down payment to buy the house.
The option fee and rent credit, in most cases (always check the contract), will be put in an escrow account and go toward your down payment.
Benefits of Rent to Own
It’s clear why renting to own a house can be a good thing for the buyer — who might not be able to purchase a home otherwise. But what’s in it for the seller?
“The landlord … gets their house rented, with a knowledge that they won’t have to pursue putting it on the market and look for a buyer after a certain period of time,” says Shea Adair, a Realtor and real estate investor in Cary, North Carolina.
“The cost alone to redo a house after a tenant and then market it to sell to a new buyer is costly,” he adds.
Basically if you’re renting your home but you’re thinking of selling it, this can be a nice way to collect rental income for a while before selling.
It also might be a good idea if you’re a seller who is having little luck convincing the market that you really do have a great home.
With renting to own, you have a buyer — the tradeoff is simply that it’s going to take a little while before you actually sell the home.
[Read: How to Find a Room for Rent]
Downfalls of Rent to Own
But while a rent-to-own house can be a wonderful buying and selling strategy for both parties, there’s a reason this isn’t something that’s done all the time: It doesn’t always work out well.
“If the tenant can’t get financing after the agreed-upon term, then you may have to evict them; otherwise they will simply be a lifelong tenant,” Adair says. “Another con for the landlord is you are locking in a future price, which could rise over time and therefore you wouldn’t be able to take advantage of that appreciation. Also, landlords don’t receive large down payments, like a seller would with a straight home purchase.”
There can be cons for the tenant as well.
For one, the rent is often a little higher than what it would be for typical homes in the area. Why? Because some of your rent is going toward a down payment. In the long run, that’s great, but if your budget is tight, a higher rent may put a crimp on things.
Of course, once it’s time to buy, you could decide to not make a purchase for whatever reason — and you might lose your down payment money depending how the contract is worded. You will definitely lose your option fee, and arguably you should since the seller was counting on you buying the home. You could also theoretically run into hard times and be unable to pay your rent — and then be evicted from your rent-to-own home. But that’s the type of risk anyone faces when living in a structure they don’t fully own.
How to Find Rent-to-Own-Homes
So you think you might want to look into buying a rent-to-own home. You have a few strategies for trying to find the right one.
Talk to a real estate agent. That’s likely your first step. Give a real estate agent a call and explain your situation. Now, they may have ideas that work for you that aren’t a rent-to-own situation, and you’ll want to hear them out, but they may immediately have clients who have struggled to sell a home and would be interested in doing the rent-to-own model.
In fact, some real estate agencies — Coldwell Banker Realty and Century 21, for example — have their own programs that offer rent-to-own homes. So your agent may be very well plugged into the whole rent-to-own scene.
Find a rent-to-own home website. You may want to look at HousingList, RealtyStore or IRentToOwn.
Suggest your idea to a seller. Depending how things go, you could suggest a rent-to-own plan to the seller of a home, which probably won’t go over so well if the homeowner has a bunch of interested buyers. But if the house has been on the market for a while, the homeowner might be interested.
Suggest your idea to a landlord. If there’s a house for rent, and you would love to own the home, you could suggest it to the landlord. The worst they can say is “No.”
Things to Keep in Mind if You Buy a Rent-to-Own Home
If you are interested in buying a rent-to-own house, approach it from the mindset of a buyer and not a renter, says Jeff Falkowski, founder of HouseReportCard.com, a website featuring reviews from real prospective buyers of homes.
How does a buyer think differently than a renter? Falkowski suggests getting a home appraisal and a title search of the home.
“It will cost from $400 to $600,” he says of an appraisal, “but is well worth the investment.”
After all, you’re going to buy the home — and more often that not, you are the one responsible for repairs while you’re renting the home. So you want to make sure you aren’t renting and then owning a complete disaster.
If you find some issues that need to be addressed, Falkowski suggests negotiating the price based on those repairs. “Or get it in writing that they will be financially responsible for fixing it. If they refuse to pay for the repairs, at least you know what you’re getting into and can decide if it’s still worth it,” he says.
A title search typically costs between $150 to $250, Falkowski says. It’s important to do one because you’ll quickly find out if the person you’re renting and then buying the house from has the right to sell the property or if there are any liens on the house.
“The owner of the house should understand you’re doing your due diligence on the property and should have no problems with any of these steps. If they are objecting and dragging their feet, that may in and of itself be a red flag,” Falkowski says.
You definitely want to be wary of the red flags. Rent to own is a perfectly smart way to purchase a home — but it can be a dangerous one, too, if you end up working with a shady home seller. That home seller could be on the brink of foreclosure. You could give the seller your option fee, move in and a few months later learn that the bank is taking possession of the house.
There is one way that you are still a renter with a rent-to-own home, however. It should be made clear in the contract that the property taxes due on the home are the responsibility of the owner of the house, and that’s not you. Not yet.
But if you do this right, working with people you trust and putting together a contract that spells everything out, you may soon find a house you can live in — and a homebuying strategy you can live with.
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Update 11/11/20: This story was published at an earlier date and has been updated with new information.