How a Rent-to-Own Home Can Pay Off for You

NEW YORK ( TheStreet) -- For buyers and sellers in a dicey housing market, a rent-to-own deal can be the perfect compromise. But how can each party know if the terms make sense?

Most people find a standard home sale challenging enough, with negotiations on price, closing dates and contingencies. But the rent-to-own deal adds other considerations: the price of the option to buy, the monthly rent and rent premium and the duration of the deal.

The seller must determine whether the deal is more profitable than an immediate sale, probably at a lower price. The buyer must decide whether the extra expenses are better than alternatives such as renting another property until it's a better time to buy.

To help with these calculations, Jack M. Guttentag, an emeritus finance professor at The University of Pennsylvania's Wharton School, has created a free online calculator on his website, The Mortgage Professor

While all terms are negotiable, in a typical rent-to-own deal the home's sales price is somewhat higher than the owner could expect to get immediately, and lower than the renter might expect to pay later. For an upfront premium that's usually between 1% and 5% of the sales price, the renter gets the option to buy anytime before the deal ends, usually in one to three years, while the owner agrees not to sell to anyone else during that period or to raise the price.

During the option period, the renter pays rent plus a monthly "rent credit" to compensate the owner for some of the risks involved. Typically, the premium and rent credits that have been paid are applied to the purchase payment if the renter opts to buy. The owner keeps those funds if there is no sale, and is free to sell to someone else after the deal expires.

Guttentag offers a checklist of issues for buyers and sellers to negotiate. The calculator allows the owner to determine whether the deal is profitable enough, and, since the profit comes from the renter, sheds light on the expense the renter would bear above the cost of an ordinary rental.

To start, the owner establishes an acceptable rate of return on the equity in the home, which is the difference between the home's value and the balance of any mortgage or home equity loan on the property.

An owner would typically demand a return comparing favorably with what could be earned on another investment, such as a mutual fund, if the equity were freed up by by an immediate sale. The return comes from the option premium, rent credit and the difference between the sales price specified in the deal and the lower price the owner could get immediately.

Guttentag provides an example in which the owner requires a 10% return over 12 months on a home worth $100,000 with equity of $40,000. Keeping the home over the next 12 months would cost $610 per month in mortgage payment and other expenses.

The example shows three ways to get the 10% return: An option premium of $1,000, rent of $610 and price of $100,660; a $1,000 premium, $501 in rent, $102,000 price; or a $654 premium, $610 rent, $101,000 price. In addition to these income sources, the return includes the gain in equity as the outstanding mortgage balance is reduced by the 12 months of mortgage payments covered by the rent.

Rent-to-own is not for everyone. But can be a good option for the seller who can't get the desired price right away and for the prospective buyer who has found a suitable home but needs time to get his financial house in order.

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