Pros and Cons of Rent to Own
A Guide for Buyers and Sellers
Rent-to-own deals are an alternative to traditional home loans. Both buyers and sellers can benefit from these arrangements, but it’s essential that everyone understands the risks.
What Is Rent to Own?
Rent to own is a way to buy or sell something over time, giving the buyer an option to purchase at some point in the future.
With a traditional home purchase and sale, the buyer and seller complete the purchase more or less immediately after agreeing to terms at closing. Under a rent-to-own agreement, the buyer and seller agree to the possibility of a sale at some point in the future. Ultimately, the renter/buyer decides if the transaction will actually take place. In the meantime, the seller receives payments, and a portion of those payments usually reduces the money needed to buy the house at a later date.
Price-to-rent is a statistic that measures the relative affordability of purchasing and renting in a housing market. For instance, in a real estate market where, on average, a home worth $100,000 could rent for $500 a month, the price-to-rent ratio is 16.67. The formula for the calculation is $100,000 / (12 x $500). We've charted the 10 U.S. cities with the highest and lowest price-to-rent ratios.
Why Buy With Rent to Own?
Rent-to-own programs can be attractive to buyers, especially those who expect to be in a stronger financial position within a few years. Here are some of its benefits:
Buy with bad credit: Buyers who cannot 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 in the same way homeowners do. However, payments can accumulate and provide a substantial sum to be put toward the home’s purchase. Buyers can also save money in a savings account and just use those funds—avoiding the pitfalls of rent to own, and providing the ability to buy any house.
Why Sell With Rent to Own?
Sellers can also benefit from rent-to-own arrangements. Here's how:
More buyers: If you’re having trouble attracting buyers, you can also market to renters who hope to buy in the future. Not everyone has good credit and can qualify for a loan, but everyone needs a place to live.
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.
How It Works
Here is the structure of the typical rent-to-own agreement:
Everything is negotiable: A rent-to-own transaction, also known as a lease option, starts with the contract. Both the buyer and seller agree to certain terms, and all the terms can be changed to fit everyone’s needs. Depending on what's important to you (whether you're a buyer or seller), you can request certain points before signing an agreement. For example, you might request a larger or smaller up-front payment if that would help you.
Advice is essential: Review any contract with a real estate attorney because these transactions can be complicated, and there is a lot of money involved. Rent-to-own deals are especially risky for buyers. Several scams 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.
An option to buy: At the beginning of any rent-to-own transaction, the buyer typically pays the seller an option premium, which is often around 5% of the ultimate purchase price (although it can certainly be higher or lower). This payment gives the buyer the right or “option”—but not the obligation—to buy the home at some point in the future.
No refunds: The initial premium payment is non-refundable, but it can be applied to the purchase price and if the buyer ever buys the home, they won't have to come up with as much cash. Larger option payments are risky for buyers: If the deal doesn't go through for whatever reason, there's no way to get that money back. The seller typically gets to keep any premium payments after a rent-to-own transaction ends.
Purchase price: The buyer and seller set a purchase price for the home in their contract. At some point in the future (usually between one and five years, depending on negotiations), 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 (otherwise, the seller is better off just selling today). 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 probably won't buy the home (partly because it might not make sense, and partly because the renter might not be able to qualify for a large loan with a high loan-to-value ratio). Buyers usually apply for a mortgage when the time comes to purchase the home.
Monthly payments: The buyer/renter also makes monthly payments to the seller. Those payments serve as rent payments (because the seller still owns the property), 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. Again, the extra rent "premium" is nonrefundable—it compensates the seller for waiting around to see what the buyer will do. The seller can’t sell the property to anyone else until the agreement with the renter ends.
Maintenance: Everyone involved benefits from a well-maintained home, but who should pay? Your agreement should specify who is responsible for routine maintenance and extensive repairs. Some agreements say that anything under $500 is the responsibility of the buyer, but local laws can complicate matters. Landlords might be required to provide certain services, even if your agreement says otherwise.
Nothing is perfect, and that includes rent-to-own programs. These transactions are complicated, and both buyers and sellers can get some unpleasant surprises. Only a local real estate attorney can advise what's at stake in your situation, so be sure to visit with one before you sign anything.
Risks for Buyers
These are just some of the things to consider:
Forfeiting money: If you don't buy the home—for whatever reason—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 downpayment.
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.
Scams: Rent-to-own scams are an appealing way to take large sums of money from people who are not in a financially secure position.
Risks for Sellers
These are some of the risks sellers face:
No certainty: Your renter might not buy, so if they don't, 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.