What is rent to own homes and how does rent to own work?
The term “rent to own” first surfaced during the 1990’s. The small lenders in a bid to find a new way to earn profit from the cash strapped consumers, came up with the idea of letting them rent a property first, with an option to buy it later.
However, as lending became easier and easier (thanks to falling rates which itself was an outcome of a growing number of lenders), the rent-to-own agreement soon lost its appeal. And by the time the 2000’s came, it was a forgotten concept. That is, until now.
The year 2016 witnessed a renewed interest among prospective buyers regarding rent to own homes. The reason? Not one but two.
First, investors get a chance to make money off the recovering housing market. Second, consumers get to lock in on a home without having to make any big down payments or without having to avail a mortgage.
Win-win for all, right?
Like two sides to every coin, the rent to own has both benefits and drawbacks for all parties concerned. We will look at them but first, we need to understand how it all works.
How Does the Rent to Own Home Process Work?
In a rent to own agreement (also called a lease to own or just lease option), prospective buyers get to move in a home right away after the deal has been made. Of course, there are certain terms and conditions that need to be met for the contract to be validated.
i) Option Fee – It is a fixed amount that the renter (or the prospective buyer) needs to pay to the seller. It is a one-time, usually non-refundable amount which provides the buyer an option to purchase the house in future. Note that paying the option fee does not constitute any obligation on the buyer’s part, but merely grants him the “right” to purchase the property when the contract expires.
If the buyer ends up buying the house, the option fee becomes part of the down payment. However, if the buyer ultimately decides to not purchase the house at the end of the lease, the option fee simply expires or in other words, becomes the seller’s income.
ii) Sale Price – The sale price or purchase price of the house is an amount that the seller and the buyer agree upon before they enter an agreement or in some cases, after the lease expires. In the first scenario, the seller and the buyer agree upon a sale price that is at or higher than the current market price of the house. Once the contract is signed, the sale price is locked in for the rest of the lease term (usually 1-3 years). No matter if the housing prices rise or fall during that period, the sale price cannot change.
On the other hand, in the second scenario, the seller and the buyer agree upon a sale price when the lease expires. The price derived is based upon the market value of the house at that point of time in future.
As is quite evident, most of the buyers prefer to go for the first scenario, wherein they try to lock in a sale price, just in case the housing prices increase in the future.
iii) Rent Premium – The term used here is “rent premium” and not simply rent. This is because in a lease to own option, the buyer has to pay a slightly higher amount than the typical rent for a property. The extra percentage of each monthly rent payment (called rent credits) goes toward the down payment for the property, if the buyer chooses to ultimately buy it. If at the end of the lease, the buyer cannot or does not choose to buy the property, the seller keeps all the money.
Apart from these, the buyer and seller must also agree upon necessary maintenance and repair requirements in the contract. Also included should be clear specifications about who is to incur other costs such as homeowners association fee, property taxes, insurance etc.
At the end of the lease term, if the buyer/renter decides to purchase the property, he/she can opt for a financing option (such as a mortgage) to pay the seller. At that point, the option fee and the extra rent credits earned by the buyer goes towards completing the transaction and settling the sale price of the property. Renttoown.
Benefits and Risks Associated with Rent to Own Homes
Benefits for Buyers
– No need for any huge down payments
– No need to worry about qualifying for a mortgage
– Buyers get ample time to repair their credit history and improve their credit score
– Buyers get ample time to build upon sufficient cash for down payment once the lease expires
– Buyers get to “try out” the house (and the neighborhood) before they actually purchase it
– By locking in a sale price and contract terms, buyers remove any risks associated with rise in housing prices
Associated Risks for Buyers
– Since the rent-to-own process is not tightly regulated, buyers can become victims of unscrupulous sellers who have no intention of ever selling their property. He/she can try to impose extreme or unusual contract agreements. e.g. A seller can make the contract void if the buyer fails to pay the rent on time even once and evict them.
– Buyers “have to” pay the option fee upfront, which can still be a sizable amount. If they don’t purchase the house in future, they end up forfeiting the amount.
– If the seller fails to pay the original mortgage on the house, it can be foreclosed and the new buyers can be forced to evict.
– Buyers usually don’t get the rent credits back (the premium they pay on top of the usual rent) when the lease expires, if they fail to purchase the house.
Benefits to Sellers
– Rent to own process allows sellers to make profit on a house they have been unable to sell off otherwise.
– Sellers can lock in a house at a higher price than the current market value and get rid of any price fluctuation risk in the future.
– A buyer is more likely to buy out a house simply because of the option fee and the rent premium that has already been invested in the house.
– Renters are more likely to treat a lease option house better if they are planning to own it in the future, than if they were to vacate in a year or so.
– Sellers earn timely rents which they can use to pay off the old mortgage and taxes on a house.
– Even if the buyer ultimately fails to purchase the property, sellers are left with the rental incomes (rent + rent credits) and the option fee.
Associated Risks for Sellers
– If the buyer backs out of a purchase when the lease expires, the sellers have to go through the entire listing process again.
– There is always the risk of a new buyer coming along who is ready to pay a higher price for the same house.
– If the renter can’t make rental payments, sellers might find it difficult to pay off the old and any new mortgages they might have availed after entering the lease to own option. The situation can lead to a foreclosure.
Because rent-to-own is still not very common and not tightly regulated (as stated earlier), both buyers and sellers must obtain assistance of a real estate attorney (on either side) while making a deal. Both parties should be fully aware of their inherent responsibilities and rights concerning the property in question. Overall, while there are many pitfalls to this process, there are plenty of benefits to avail for everyone concerned as well. Sellers get to earn money off the otherwise unsaleable or vacant properties, and buyers are provided with an affordable housing option to become homeowners in near future.