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

Key Takeaways:

  • Rent-to-own deals let a buyer rent the home for a time before committing to the purchase.
  • Whether the deal is a lease option or lease purchase agreement affects the level of commitment.
  • Both buyer and seller must watch out for risks that come with this type of arrangement.

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.

What Is Rent-to-Own?

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.

Types of Rent-to-Own Agreements

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.

How a Lease Option Works

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.

How a Lease Purchase Works

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.

Pros and Cons of Rent-to-Own

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

Pros for Buyers

  • Gain automatic equity. You’re building equity with every rent payment.

  • Lock in savings. By setting the purchase price now, you may be able to avoid higher home prices when it’s time to buy.

  • Boost your credit score. Buying a rent-to-own home gives you time to improve your credit score before it’s time to apply for a mortgage. 

  • Test out the neighborhood. See what it’s like living somewhere before you commit to buying.

Cons for Buyers

  • It’s a complicated deal. Rent-to-own agreements add complexity to the purchase process.

  • You could lose money. If you don’t buy the home, you could lose the option fee and the rent credits you’ve been paying.

  • It still might be tough to finance later. It’s not guaranteed you’ll be able to qualify for a mortgage when it’s time to buy, especially if the purchase price doesn’t match the appraised value.

  • You could overpay. If the home doesn’t appreciate as you expect, you might be overpaying when it’s time to close.

Pros for Sellers

  • Widen your pool of buyers. Rent-to-own deals could attract potential buyers who may not have perfect credit or the cash for a down payment yet but are still interested in buying a home.

  • Get a higher sales price. Pricing the home with appreciation in mind can help you lock in a profit.

  • Decrease your maintenance responsibilities. Your tenants may take on more maintenance in anticipation of owning the home later.

  • Potentially pocket option fees. You may be able to retain the option money, even if the sale does not finalize. 

Cons for Sellers

  • You could leave money on the table. If the home appreciates more than expected and you have committed to a lower sales price, you could miss out.

  • Built-in delays. If the deal doesn’t work out, you’ll have to start the sales process all over again.

How to Safeguard Your Interests in a Rent-to-Own Deal

“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:

  • If the seller doesn’t make their mortgage payments during the lease, the home could go into foreclosure even if the buyer has been making rent payments on time.
  • If the buyer doesn’t make rent payments, they could lose the option to buy and may even lose the money they’ve put toward the down payment.
  • The purchase price both parties agree on at the beginning of the deal may not match the home’s market value when it’s time to transfer ownership.

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 vs. Traditional Mortgages

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

Rent-to-Own Traditional Mortgage
No guarantee the sale will be completed, especially with lease option deals. Buyer takes ownership as soon as the deal is closed.
Deal involves an option fee instead of a down payment. Purchase requires a down payment (with the exception of certain loan programs).
Monthly payments include rent plus a portion that goes toward future equity. Monthly payments include principal, interest, taxes and insurance.
Provides a flexible path to home ownership. Provides an immediate path to home ownership.

Is Rent-to-Own Right for You?

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.

Sarah Goldberg
Sarah Goldberg

Sarah is a seasoned financial market expert with a decade of experience. She's known for her analytical skills, attention to detail, and ability to communicate complex financial concepts. She holds a Bachelor's degree in Finance, is a licensed financial advisor, and enjoys reading and traveling in her free time.

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