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How Do Rent-to-Own Homes Work?

Renting-to-own allows individuals to boost their credit score and apply their rental payments toward the down payment for the home. But there are also risks.
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While some consumers choose to buy a home, it is a simple, sad fact that not everyone has that luxury. What do those people do in their effort to find somewhere to live?

Those other people with financial constraints may decide to rent a home with the option to purchase it in the future. This process is known as rent-to-own, and while it's not the most common method used in the home-buying process, it remains an option for those in the market for a new home to consider. But what is it, why is it a smart move for some people, and why have others chosen to avoid getting rent-to-own homes?

How Do Rent-to-Own Homes Work?

Rent-to-own homes allow people to buy the home they are leasing and use the rent they have paid as a credit toward their mortgage down payment.

The specifics of the contract will differ, but the general idea is that the prospective tenant/buyer will sign a contract to rent the home with an option for them to purchase the house at the end of the lease. The time period where they can live in the house before a lease expires is often between 1-5 years, and when they buy the house, a portion of the rent payments during the lease goes toward putting down a down payment. Ideally, this takes a sizable chunk out of the purchase price.

Let's say you're living in the home for 3 years before deciding to purchase it. The purchase price is $300,000. Your monthly rent is $1,650, and $300 of that goes toward the down payment. By the time the lease expires and you're prepared to purchase the house, you've already given a $10,800 down payment over three years. That's nearly 4% of the original purchase price, knocking it down to $289,200.

How the purchase price of the house you're renting to own can vary as well. Some contracts stipulate that the purchase price will stay what it was when the initial contract was signed, while others have it be the market value of the house at the time of purchase. Some contracts eschew each of these for a different method entirely, having the purchase price go up a certain percentage every year of the lease. Rent-to-owners can decide to buy the house any year of that lease.

There are generally two different types of rent-to-own deals: a lease-option agreement and a lease-purchase agreement.

What is a Lease-Option Agreement?

In a lease-option agreement, you will have to give a usually nonrefundable payment at the beginning of your lease term. This payment, known as option money, is a small percentage of the purchase price of the rent-to-own house. If the aforementioned $300,000 rent-to-own house had a contract stipulating 3% in option money, you would be required to pay $9,000 at the beginning of the contract.

Should you buy the house, that option money goes toward the purchase price of the house, which would now be $291,000. If, however, the lease expires and you decide not to go through with a purchase of the house, that money has been forfeited. You won't get it back.

What is a Lease-Purchase Agreement?

A lease-purchase agreement does not involve any option money, but there is much more that it sets in stone. The date of purchase is established, as is when the purchase price will be established (aka, will it be the price it is at the signing of the contract or the price of a home appraisal at an established future date?).

In building a down payment with the aforementioned percentages of rent, that monthly payments may be higher than your average rent in the area.

Rent-to-Own Pros and Cons

The positives of rent-to-own are that it can try to help make the home buying process simpler and more convenient for people who, for a number of reasons, do not have the money to put a down payment down on a house right now.

In a sense, it can slow down the process in a beneficial way for the buyer. Someone with bad credit now not only has a place to live, but a timetable to try and get their credit to a more respectable level in time for the lease to end and a purchase to be made. Someone down on their luck with regards to jobs and illnesses has time to recover physically, mentally and financially without the stress of worrying about their living situation.

Negotiating your rent-to-own contract has potential for additional positives as well. You're free to try and get the deal you want from the home before signing a contract. You can try to negotiate the purchase price, rent payments, and who is responsible for maintenance.

These are extremely important, especially if they go your way. Getting the house for current market price looks great if prices rise in the next few years, and having the landlord be responsible for major maintenance is a huge help for someone saving money for a down payment.

Doing proper research on a house that you can rent-to-own can help save you from being stuck with a house in desperate need of expensive repairs. A prepared prospective tenant has a better chance of finding a livable rent-to-own house.

Rent-to-Own Cons

Although this appears to be a good strategy for potential homeowners who have a low credit score or do not have enough money for a down payment, there are some potential disadvantages.

Homeowners need to check the laws in their state, because it varies. One problem that could arise is what happens in the event the individual misses a payment.

Before a contract is signed, consumers should discuss the issue with a lawyer, said David Reiss, a law professor at Brooklyn Law School. In a worse-case scenario, if the individual was unable to make payments because of the loss of a job, he could lose all the payments he made previously.

"There are a lot of shady operators out there since rent-to-own transactions can be very complicated," he said.

Since there are not many consumer protections available, potential homeowners should be aware of all the options.

While this method is alluring to many people, especially younger buyers or those who have never owned a home, the possibility of "losing all the money" you have allocated toward buying the house can be a deterrent, said Larry Link, president of Level Group, a New York City brokerage firm. 

Many of these arrangements are complicated, so consumers should read the fine-print and make sure all questions are answered before the ink is dry.

Here are some of the issues that a buyer needs to be aware of before embarking on the rent-to-own strategy.

If you miss a payment or two due to a hardship, job loss or illness, your entire investment could vanish. With a traditional mortgage, the amount of equity the owner has earned remains the same.

Another potential problem arises if the housing prices start to dip. Since the potential homeowner has locked in the price of the house, they are also stuck with it if values in the neighborhood start to fall.

Rent-to-own housing can be tricky because the landlord might decide the potential homeowner is responsible for repairs and property taxes during the lease period, said Rich Verrillo, a senior housing partnerships manager for Navicore Solutions, a Manalapan, N.J.-based member agency of the National Foundation for Credit Counseling. Working out all the details before the contract is signed is vital.

Homeowners still need to boost their current credit score to make sure they are approved for a mortgage when they are ready to purchase the home. Failing to qualify for a mortgage could mean losing the upfront option-to-buy fee or premium, he said.

Why Do People Choose Rent-to-Own?

Some individuals prefer the rent-to-own option because the burden is decreased for the tenant. The risk for the two parties will be divided when the contracts are balanced.

It gives people the ability to test out a home and the neighborhood before sinking in all their savings.

As the number of available homes in the market or a particular neighborhood can shrink and mortgage interest rates are rising, it is a good test run for many individuals, said Monica Webster, a managing director for William Raveis, a Shelton, Conn.-based real estate firm.

"It's a no-brainer," she said. "You can get your financials in order. If it's a great location and area you want, you can't go wrong. One tip is to see if some or all of the rent can be applied to the down payment."