Several general rules of thumb exist in the home-buying arena. Some apply perfectly to prospective homebuyers and others miss the mark altogether. One of the more confusing schools of thought out there is the idea that if you can afford to rent, you can afford to own. Renting feels a lot like throwing money at nothing since you aren’t building equity in a property over time. However, there are times when renting makes the most sense based on credit standing and the feasibility of bringing a down payment to the table.
But what about rent-to-own agreements? Are they a happy medium not-yet-ready buyers?
In the wake of the 2008/2009 recession and housing market shift, rent-to-own opportunities flooded the market. Historically, giving renters an option to purchase a home at a later date was offered by individual homeowners. However, many banks started making these offers available from their portfolio of foreclosed properties as well. The influx of rent-to-own opportunities has brought this home-buying strategy back into the limelight. But buyers beware. While rent-to-own may sound like a smart financial move, it is, more often than not, a less sound option than buying a home.
Here’s how it works and the reasons why you might consider a different solution to home-buying.
If you’re wondering how rent-to-own agreements work, the answer is all in the name. Property owners give prospective buyers the option to sign a rental agreement to lease the home for a set period. This typically ranges from one to three years. The rental agreement for a rent-to-own situation reads similarly to your standard rent contract, except there is some language in the lease that differs. Essentially, renters have first dibs on purchasing the home after their lease ends.
When signing a rent-to-own lease, potential buyers may be required to pay an option fee. This expense is collected at the time you sign the rental agreement, and it gives you, the renter, rights to purchase the home without competition from other buyers during your lease. The fee paid is credited toward the home’s purchase, but if you ultimately decide not to buy, the fee disappears into thin air – in other words, you do not get it back.
In most rent-to-own scenarios, a portion of the rent paid each month goes toward the future purchase of the home. However, the percentage or dollar amount of rent credited to the future purchase isn’t the same from property to property. Renters may have the option of paying higher rent, so more money is paid toward the purchase credit over time, but this isn’t always the case. The purchase price of the home may also be set at the beginning of the rent-to-own agreement, but again, this varies. Because these terms are dictated by the landlord, renters who plan to own a home must be sure to read the fine print carefully.
A rent-to-own agreement mostly benefits the property owner first. They collect rent payments for a set period and then have a high probability of selling the home once the lease is up. Sellers also benefit when rent-to-own agreements are structured in a way where the monthly rent is higher than the market would otherwise dictate. A property owner may also get a fairly good deal on the sale of the home when the purchase price is agreed upon at the time a lease is signed – not at the time the property is actually sold.
Rent-to-own agreements most often nod to the seller, but a small subset of potential buyers may benefit from this type of contract. If credit history is an issue, securing an affordable mortgage with a lender to purchase the home now may not be realistic. Renting-to-own gives buyers time to improve their credit history and score. Additionally, buyers who do not have an adequate down payment and do not qualify for a downpayment assistance program can benefit from rent-to-own agreements. The portion of rent credited to the future purchase is held in an escrow account by the landlord. When the time comes to buy, those funds are available for the down payment requirements.
Very few situations make rent-to-own agreements worth it for you, the potential buyer. That’s because there are more downsides than there are advantages. First, the option deposit due when signing a rent-to-own lease can be a significant expense. The amount is calculated as a percentage of the future purchase price, but that percentage can range from 2.5 up to 7.5%. If you think of this fee in terms of mortgage down payment requirements, you may be paying far more for an intangible benefit with rent-to-own upfront fees. For instance, an FHA mortgage requires a 3.5% down payment. If you have that amount available for rent-to-own fees, you have the ability to purchase.
You also need to think through the amount of each month’s rent that is set aside for the purchase credit. That could be a measly 15 or 20% of your rent payment each month. But the real kicker is that rent-to-own leases often come with higher monthly rent obligations. If you’re paying $2,500 for rent on a place that should cost $2,000, simply for an option to buy in the future, you’re throwing money down the drain. Of that $2,500, let’s say 20%, or $500, is going toward your purchase credit. In theory, by the time you end your lease in three years, you would have $18,000 in escrow with the property manager. That would be used for your down payment in most cases. This sounds great, but you could achieve the same outcome, without restrictions mentioned below, on your own.
And remember, the upfront fee paid to get into the rent-to-own contract is often a sunk cost from the start.
Above and beyond the dollars and cents of rent-to-own agreements, renters have a long list of responsibilities. Maintenance and upkeep of the home fall on your shoulders. HOA fees, property insurance, and some repairs may also be the burden of the renter. Since you plan to own the home in the future, the seller may transfer these responsibilities to your plate while you rent. If you fail to keep up, you could lose your option to buy – without a refund of your money.
Finally, renters can lose out when actually purchasing the property. This is particularly true when the purchase price is set at the time the lease is signed, not when it is sold. If the property value falls during the lease, the seller wins. The purchase price may not be easily negotiable, either. This often puts renters in a difficult spot when the time comes to push the purchase button.
Overall, rent-to-own agreements only work for a very small group of potential homebuyers. Those who have bad credit may use the timeframe of their lease to improve it. With two or three years of on-time payments and responsibly managing credit, renters are likely to qualify for the mortgage they need to buy. Unfortunately, rent-to-own contracts come with more downsides than benefits. If you can pay the option fee and higher rent, you can likely afford to purchase now. Instead of throwing your money away with rent-to-own, it makes more sense to consider your options for purchasing, not renting, your home.
Still not sure what the best decision is for you? Give us a ring and we can help you figure it all out.