When thinking about how to finance a home purchase, you might be confused when hearing terms such as "rent-to-own" and "seller financing." While these two ways to buy a home may sound alike, they differ in some basic ways. The key factor that both have in common is that they can assist buyers who have less-than-perfect credit in starting down the path to owning a home.
Rent-to-Own vs. Seller Financing
While renting a home with the goal of owning it and seller financing both involve paying the owner of the home while you live there, you will find some distinct differences between the two methods of purchase.
With most rent-to-own programs, the buyer has the “option” to buy the home at some time in the future. The buyer lives in the home as a renter. Until the renter buys the home, the owner is also the landlord and remains the true owner of the home. The owner's name is on the deed, and that’s the person who is responsible for making mortgage payments on the home. If the owner owns the home outright, this would not apply. The renter has the right to purchase the home someday but is not obligated to do so. What's more, the deal can fall through, and the buyer/renter might not ever end up owning the home.
With owner financing, ownership of the home changes hands from the start. The buyer becomes the new owner at closing. Rather than making payments to a lender, the buyer will make payments to the former owner. In some states, such as Michigan, the seller is legally considered the mortgage lender. The buyer is paying off a loan for the purchase that has already happened, and they are the owner of the home. One example of seller financing is a wraparound mortgage.
A crucial difference between these two ways of buying a house is the timing of when the home changes hands. In the case of a seller being the lender, the change of ownership takes place right away. With rent-to-own, the renter does not become the owner until a time that may be years down the road.
Similarities, Differences, and Risks
Although rent-to-own differs from seller financing, there are some things the two have in common. In either case, the buyer might make payments to the seller until the buyer takes out a loan from a bank. In most cases, the buyer will apply for a loan with a bank or mortgage lender. During this time, the buyer should be working on building good credit in order to qualify for a loan. Both of these methods of buying a home offer options for those with poor credit to move into a home without waiting for a bank’s mortgage approval. Again, the main difference has to do with when ownership officially transfers.
The timing of a change in ownership is vital because each party carries different risks, depending on whether they own the property. For instance, in a rent-to-own deal, buyers take a risk that the owner will fail to make mortgage payments and lose the property through foreclosure. If this were to happen, buyers might have been better off with seller financing or buying the home with a traditional loan. Buyers also run the risk of the deal falling apart if they can't make monthly payments.
Other risks that buyers may assume in rent-to-own situations include the following:
The seller isn’t actually the true owner, or the seller fails to make promised repairs upon sale. There’s also the possibility that you’ll end up more in fees or higher monthly payments than if you simply rented a place while saving up for a traditional down payment.
With the examples above, you might assume that it’s always better to be the owner of the home, but owners also take on substantial risks. Sellers have a great deal at stake when they offer owner financing: If the buyer doesn’t pay (or can’t get a loan), the seller may need to foreclose on the home. That means paying legal fees and evicting the buyer, not to mention finding another buyer. All of these activities consume your time, energy, and money.
With either type of program, there are numerous complications and things that can go wrong. That’s not surprising, given that you have two (or more) parties with interest in a property. If you’re considering either of these strategies, be sure to research the risks by speaking with a local real estate attorney. It’s hard to envision all of the pitfalls in advance, but there are too many of them to ignore, and a professional can help you figure out if the benefits are worth the risks.
- Both rent-to-own and seller financing can help homebuyers purchase property when traditional lenders are unwilling to approve a loan.
- These strategies can also benefit homeowners by providing a bigger pool of buyers.
- It’s critical to understand when ownership changes hands, along with the pros and cons of owning the property (or not).