When trying to secure home financing, it's easy to confuse a rent-to-own transaction with seller financing. These two approaches may sound similar, but there are some important differences. The key factor that both have in common is that they both can assist buyers who have less-than-perfect credit in starting the path to homeownership.
Rent-to-Own vs. Seller Financing
With most rent-to-own programs, the buyer/renter has the “option” to buy the home at some time in the future. Until that time, the owner/landlord remains the true owner of the home. The owner/landlord’s name is on the deed, and that’s the person who is ultimately responsible for mortgage payments (if any) on the home. The renter has the right to purchase the home someday, but the renter is not obligated to buy. 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 property changes hands at the beginning: The buyer/renter becomes the new owner at closing. The buyer will pay the former owner (perhaps for several years) in a way that may appear very similar to a rent-to-own transaction. But the buyer is paying off a loan after a purchase that has, in fact, happened—not making rent payments (or other payments that might be applied toward a hypothetical purchase that may or may not ever take place).
A critical difference between these two strategies is timing. When does the change of ownership take place?
Similarities, Differences, and Risks
Although rent-to-own is very different from seller financing, there are some similarities. In either case, the buyer might make payments to the seller until the buyer takes out a loan from somewhere else (typically, the buyer will apply for a loan with a bank or mortgage lender). During this time, the buyer is ideally working on building credit in order to qualify for a loan. Both of these alternatives 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 important because each party carries different risks, depending on whether or not they own the property. For example, in a rent-to-own transaction, buyers take a risk that the owner/landlord will fail to make mortgage payments and lose the property through foreclosure—in that case, 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 (especially if the owner is motivated to take advantage of the situation).
Other risks that buyers may assume in rent-to-own situations include: 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).