How Does Rent-to-Own Work? | Mortgages and Advice

What if renting actually helped you put money toward your own home? That’s the basic design of rent-to-own properties: Live in your new home before you buy it, with a portion of your rent payments building equity while you wait.

With rent-to-own homes, the buyer and seller agree to a purchase price (sometimes years in advance), and then the buyer rents the home until the purchase date. Some of the money they pay each month goes toward rent and some is set aside for the purchase. When it’s time to transfer ownership from seller to buyer, the buyer has a down payment ready to go, plus several years of steady payments to show to a potential mortgage lender.

The seller, for their part, collects rent and has a willing buyer occupying the property, even if the purchase date is many years away.

However, rent-to-own deals come with some risks. Before you buy (or sell) a rent-to-own home, it’s important to understand how these arrangements work, the pitfalls you could face and how to protect yourself in the deal.

There are two main types of rent-to-own agreements. The first type is a lease option and it’s essentially a rental agreement that gives the buyer the option (but not the obligation) to purchase the home later.

The second type is a lease purchase, in which the renter promises to purchase the home in the future. Lease purchases leave buyers with little wiggle room to get out of the deal if circumstances change.

In a lease option, the renter and seller agree on the purchase price and length of the lease. The renter pays an upfront fee, called an option fee, that secures their right to buy the home later. The renter pays rent each month plus an additional amount that the seller sets aside for the future down payment.

With a lease purchase, the renter commits to buy the property at the end of the lease. Lease option and lease purchase agreements are binding contracts, so both parties must agree on terms ahead of time.

“It is absolutely worth the investment to consult with an attorney” on these types of deals, says Nikki Beauchamp, an associate broker with Sotheby’s International Realty.

There are advantages and disadvantages for both the buyer and seller in rent-to-own arrangements.

“Rent-to-own agreements can be very risky” for both parties, says Nathan Vogt, certified mortgage banker and president of the mortgage division at First Horizon Bank. He says he typically advises against rent-to-own deals in favor of low-down-payment mortgage options.

Consider some of the things that could go wrong with rent-to-own homes:

Jeremy Schachter, branch manager at Fairway Independent Mortgage Corporation, cautions buyers to negotiate a rent-to-own home carefully.
“Let’s say you decide to purchase a home in two years for $450,000, based on appreciation in the future,” he says. “What happens if the home doesn’t appraise for that amount in two years?”

Rather than overpay for the home, Schachter suggests potential buyers request an appraisal to determine its current value. If the home doesn’t appraise at that price, the sales price should be reduced.

Rent-to-own deals have some key differences compared to traditional mortgages.

Rent-to-own might be an appealing route for people with a thin credit file or who haven’t built a credit history, both of which can make it tough to get a mortgage. It can also be useful for first-time homebuyers who haven’t saved for a down payment or are trying to find and test-drive a home in a hot housing market.

Before you enter a rent-to-own agreement, make sure you’ve read the fine print on the contract and consider other homebuying alternatives, including condos, co-ops and traditional mortgages.