Definitions and Examples of Rent-to-Own
Rent-to-own contracts are alternatives to traditional home loans. At the outset, such arrangements are much like traditional leases landlords and tenants might sign. However, the contract also gives the renter exclusive rights to purchase the home at a specified point in the future. A portion of the money paid upfront and a part of the established monthly rent also go toward the purchase price.
Any two parties can enter into such an arrangement, but they sometimes are used as part of housing programs designed to establish affordable housing or revitalize neighborhoods.
How Does Rent-to-Own Work?
The buyer and seller establish a purchase price for the home in their contract. At some point in the future, the buyer can purchase the home for that price—regardless of what the home is actually worth.
When setting the price, a price that’s higher than the current price is not uncommon, to account for projected increases in home values. If the home has gone up in value faster than expected, things work out in the buyer's favor. If the home loses value, the renter can back out of the deal. Buyers usually apply for a mortgage when the time comes to purchase the home.
There are two types of rent-to-own agreements. Lease-option agreements give the option to buy the home at the end of the lease. Lease-purchase agreements establish the obligation to do so.
Buyers typically pay an option premium upfront, often up to 5% of the ultimate purchase price. The payment is nonrefundable, but it can be applied to the down payment.
Contracts also establish the amount of monthly rent, but the renter typically pays a little bit extra each month. The additional amount is usually credited to the final purchase price, so it reduces the amount of money the buyer has to come up with when buying the home. The extra rent is nonrefundable. It compensates the seller for agreeing not to sell the property to anyone else until the agreement with the renter ends. Contracts should also stipulate who is responsible for maintenance during the rental period.
Is Rent-to-Own Worth It?
Rent-to-own agreements make sense for some buyers, but not for others. If you have shaky credit or need time to save a down payment, rent-to-own may be the right choice for you. A lot depends on your finances and the state of the housing market.
A price-to-rent ratio measures the relative affordability of purchasing vs. renting in a housing market. It is calculated by dividing the median price of homes sold during a specific time period in a particular market by 12 months' worth of the median monthly rent in that same market.
For example, the median price of homes sold in the U.S. during the fourth quarter of 2021 was $408,100, while the median monthly rent paid during that same time nationwide in the 50 largest metros was $1,771. So, to get the price-to-rent ratio, you would divide 408,100 by 21,252 (1,771 multiplied by 12) and come up with 19.2. The higher the ratio, the more favorable the market is for renting. The lower the ratio, the more favorable the market is for buying.
Of course, average home prices and rents vary from market to market, so the national average provides little more than a broad overview. To be accurate, you need to base your calculation on current figures where you are planning to buy or rent.
Pros and Cons of Rent-to-Own for Buyers
Buy with bad credit
Lock in a purchase price
Test drive before buying
Move less often
Build equity in the long run
May forfeit money
Slow financial progress
Home prices may fall
Late payments hurt
Could be issues with the home
- Buy with bad credit: Buyers who can't qualify for a home loan can start buying a house with a rent-to-own agreement. Over time, they can work on rebuilding their credit scores, and may be able to get a loan once it’s finally time to buy the house.
- Lock in a purchase price: In markets with increasing home prices, buyers can get an agreement to buy at today’s price with the purchase taking place several years in the future. Buyers have the option to back out if home prices fall, although whether or not it makes sense financially will depend on how much they have paid under the agreement.
- Test drive: Buyers can live in a home before committing to buy the property. As a result, they can learn about issues with the house, nightmare neighbors, and any other problems before it’s too late.
- Move less: Buyers who are committed to a home and neighborhood (but unable to buy) can get into a house they’ll eventually buy. This reduces the cost and inconvenience of moving after a few years.
- Build equity: Technically, renters do not build equity the same way homeowners do. However, payments can accumulate and provide a substantial sum to be put toward the home’s purchase.
- Forfeiting money: If you don't buy the home, you lose all the extra money you paid. Sellers may be tempted to make it difficult or unattractive for you to buy so they can pocket your investment.
- Slow progress: You might plan to improve your credit or increase your income so you’ll qualify for a loan when the option ends, but things might not work out as planned.
- Less control: You don't yet own the property, so you don’t have total control over it. Your landlord could stop making mortgage payments and lose the property through foreclosure, or you might not be in charge of decisions about major maintenance items. Likewise, your landlord could lose a judgment or quit paying property taxes and end up with liens on the property. The agreement should address all these scenarios. The landlord isn’t allowed to sell while you have an option on the property, but legal battles are always a major headache and expense.
- Falling prices: Home prices might fall, and you might not be able to renegotiate a lower purchase price. Then you’re left with the option of forfeiting all your option money or buying the house. If your lender won’t approve an oversized loan, you’ll need to bring extra money to closing for a down payment.
- Late payments hurt: Depending on your agreement, if you don't pay rent on time, you may lose the right to purchase, along with all of your extra payments. In some cases, you keep your option, but your extra payment for the month is not counted, and won’t add to the amount you’ve accumulated for eventual purchase.
- Home issues: There might be problems with the property you don't know about until you try to buy it—such as title problems. Treat a rent-to-own purchase like a real purchase. Get an inspection and title search before diving in.
Advice is essential. Rent-to-own deals can be especially risky for buyers, and several scams aim to take advantage of people with poor credit and high hopes of buying a home. Even with an honest seller, it’s possible to forfeit a lot of money if things don’t go as planned. Review any contract with a real estate attorney.
Pros and Cons of Rent-to-Own for Sellers
Higher sales price
Renter might not buy
Earn money slowly
Falling home prices
- More buyers: If you’re having trouble attracting buyers, you can market to renters who hope to buy in the future.
- Earn income: If you don’t need to sell right away and use the money for another down payment, you can earn rental income while moving toward selling a property.
- Higher price: You can ask for a higher sales price when you offer rent-to-own. People may be willing to pay extra for the opportunity. Renters also get the option to buy the house—which they might never use—but flexibility always costs more.
- Invested renter: A potential buyer is more likely to take care of a property and get along with neighbors than a renter with no skin in the game. The renter/buyer is already invested in the property and has an interest in maintaining it.
- No certainty: Your renter might not buy, which means you have to start all over again and find another buyer or renter—but at least you get to keep the extra money.
- Slow money: You don't get a large lump sum, which you might need to purchase your next house.
- Missing appreciation: You typically lock in a sales price when you sign a rent-to-own agreement, but home prices might rise faster than you expected. You have to accept this or wait a while to offer the option to buy.
- Falling home prices: Home prices might fall, and if your renter does not buy, you would have been better off simply selling the property.
- Discovering flaws: Buyers may discover flaws you never knew about and they may decide not to buy. For example, the plumbing might be adequate for a couple, but not a family of five. Although this defect never came up under the previous living arrangement, it is now an issue you’ll have to fix or disclose to future buyers.
Everything is negotiable in a rent-to-own transaction. Both the buyer and seller agree to certain terms, and all the terms can be changed to fit everyone’s needs.
- Rent-to-own contracts allow prospective homebuyers to lease a property with an option to buy.
- The contract gives the renter the option to buy the home at a specified point in the future.
- Part of the monthly rent goes toward the purchase price of the home, allowing the leaseholder to save toward the down payment.
- Buyers typically pay a nonrefundable premium upfront, often up to 5% of the purchase price.