Are you ready to purchase a home but your lack of a down payment and low credit score are getting in the way? Do you want to sell a rental property but you’re having difficulty doing so? A rent-to-own agreement may be an option worth exploring. Let’s take a look at how rent-to-own agreements work and the pros and cons associated with them.
How Rent-to-Own Agreements Work
A rent-to-own agreement allows prospective homebuyers to rent a property for a period of time (commonly two to five years) before purchasing it. There are generally two types of rent-to-own agreements: lease-purchase and lease-option.
A lease-purchase agreement consists of two separate contracts: (1) a residential lease agreement that identifies the rental term, monthly rent payment, and the responsibilities of the tenant/buyer and landlord/seller during the leasing period; and (2) a purchase contract that sets forth the agreed-upon purchase price and other applicable terms that will go into effect after the expiration of the lease. Rent payments for lease-purchase agreements are often set higher than the fair-market-value so a portion of it can be applied towards a down payment.
A lease-option agreement operates similar to the lease-purchase agreement in that it consists of two agreements and enables the tenant to purchase the property. However, the tenant does not sign a purchase contract but instead enters into an option agreement, which acknowledges that the tenant/buyer has the right to purchase the property but is not obligated to do so. A non-refundable option fee is often required to secure the option to purchase the property. The option fee typically runs between one percent and five percent of the purchase price.
Both agreements can include what is referred to as a cross-default provision, which assures that the breach of one agreement results in the automatic breach of the other. For instance, if the tenant/buyer stops making monthly payments, the lack of payment would be a breach of the lease agreement and would automatically breach the purchase contract as well.
Pros and Cons of a Rent-to-Own Agreement
Rent-to-own agreements have advantages and disadvantages for both the buyer and the seller. Let’s take a look at some top pros and cons:
• Provides a homeownership trial run. Tenants can use a lease-option agreement to determine if they like the house and the neighborhood before purchasing it. This is particularly beneficial for individuals who want to explore a new location.
• Opportunity to repair credit scores. In order to qualify for a conventional mortgage loan, most lenders require a credit score of 620 or higher. If a low credit score is getting in the way, a rent-to-own agreement can help tenants move towards homeownership while also taking steps to secure a viable credit score.
• More time to secure a down payment. According to research conducted by the National Association of REALTORS®, since 2018, the typical down payment for first-time homebuyers has ranged between six to seven percent of the purchase price. Instead of having to come up with a lump-sum payment, a portion of the rent payment can be allocated towards the down payment.
• Ability to build equity. If the market value of the property increases above the agreed-upon purchase price, the tenant/buyer automatically begins to build equity.
• Avoid moving at the end of the rental term. If the tenant decides to purchase the home, there is no additional hassle or costs of moving.
• Additional way to attract buyers. Offering a rent-to-own agreement is a way for sellers to attract a wider range of buyers, particularly those who are ready to own a home, but need more time to secure financing.
• Steady revenue and other financial incentives. A reliable long-term tenant secures a steady flow of income. Also, if the tenant defaults on the monthly payment or breaches the terms of the agreement, the landlord/seller may be able to keep the down payment and any other non-refundable fees and costs.
• Non-refundable upfront fee. Depending on the terms of the agreement, an upfront non-refundable option fee may be required to secure the option to purchase the home at the end of the rental term.
• Responsible for maintenance and repairs. The landlord/seller may include a term in the agreement that states the tenant is responsible for any maintenance and repairs to the house during the rental term, even though the title to the property still remains with the landlord/seller.
• Lost down payment and any other non-refundable fees. At the end of the rental term, if the tenant decides not to purchase the house or is unable to secure financing, the seller may be able to keep the down payment and any other funds remitted by the tenant. The same may also be true if the tenant defaults on monthly payments at any time during the rental period.
• Vulnerable to scams. There is the risk that the transaction is a rent-to-own scam, which exploits the tenant/buyer. These include situations in which the seller does not actually own the property, the property is delinquent in mortgage or property tax payments, or the house requires a laundry list of repairs that are not disclosed to the tenant/buyer.
• Tenant/buyer can default on payments. If the tenant/buyer defaults on monthly payments, not only is there a breach of the rent-to-own contract, but the landlord/seller may also be forced to perform an eviction. Eviction proceedings involving a rent-to-own contract can be complex and must adhere to state laws.
• Tenants do not always end up purchasing the home. With a lease-option agreement, there is no guarantee that the tenant will purchase the home at the end of the lease period.
• Unrealized appreciation. If the agreement included a locked-in purchase price, the seller will be obligated to sell the house at that price, even if the market value appreciates.
Making the Choice
Rent-to-own agreements allow individuals to rent their future home until they’re financially ready to purchase it. Potential homebuyers and sellers should do their due diligence when reviewing the terms and conditions of a rent-to-own agreement, assessing the condition of the home and considering the pros and cons before signing the dotted line. Seeking the assistance of a real estate professional or attorney who specializes in rent-to-own homes or utilizing a rent-to-own program can help those considering this option navigate the process and put both parties at ease. For more helpful resources on the home buying and closing process, visit Old Republic Title.
This material is for educational purposes only and does not constitute legal advice. Old Republic Title strongly recommends that consumers obtain guidance and advice from qualified professionals, including attorneys specializing in real property law, probate law, or tax law to get more detailed and current information as to their particular situation.