How Does Rent-to-own Home Work?

The concept of rent-to-own home means that a buyer pays rent for a house, and a part of it goes towards the down payment to buy that same house later. Through this Buzzle article, you will understand how rent-to-own homes work.
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Rent-to-own home concept explained
There could be a house in a neighborhood that you really want to settle in but for whatever reason you can't qualify to buy a home. Instead, you can qualify to rent one that you'd like to be able to buy in the future. Thus, rent-to-own especially appeals to former homeowners who want to get back into ownership.
― Barry Zigas, Director of Housing Policy, Consumer Federation of America
The real estate and housing industry is fairly unpredictable, and as of today, the sector is booming like no other; however, it has its own share of pitfalls. While in some parts of the country, houses are being sold quickly and efficiently, the situation is quite different in other parts. Selling a house can be difficult, stressful, and time-consuming, hence newer laws and strategies are formulated to ease the situation for buyers as well as sellers. One of those strategies is a 'rent-to-own home'. Now, you must be wondering why would one pay rent to own a home. The paragraphs below will help you understand how this concept works.

How Does it Work?
  • Consider a situation, where a seller has two houses, and he wants to sell one of them. However, there seems to be no prospective buyer, and the ones who exist do not have enough down payment, or they have a bad credit score. In such a scenario, the rent-to-own home or lease purchase option can be a great solution.
  • In this strategy, the potential buyer agrees to become a tenant in the seller's house for a set period, usually 3 years.
  • While the buyer pays a monthly rent, a part of it goes into the seller's income, while some part of it goes towards the down payment of the house.
  • This means that at the end of 3 years, the buyer will have a decent credit score as well as accumulated enough money to pay as down payment to own the house.
  • The tenant also has to pay an option fee and a rent premium. The option fee is a fixed amount that the buyer needs to pay the seller.
  • After the lease period gets over, if the buyer still wants to buy the house, the option fee becomes a part of the down payment. If he does not buy the house, the option fee becomes an extra income for the seller.
  • Also, once the agreement is signed, the sale price of the house is locked in until the end of the rental term, i.e., the lease period. During this period, even if the property prices rise or fall, it will not affect the price of this house, the original agreed-upon price is final.
  • The option fee that is mutually agreed upon gives the buyer an exclusive right over the house, such that only he can buy the house, and the buyer cannot sell it to anyone else.
  • During the rental period, the seller still owns the home and is legally responsible for it, but the tenant often maintains the property as his/her own.
  • Certain terms and conditions have to be specified on the rental agreement to cover unavoidable or unexpected circumstances.

Example

Let us assume that a person wants to sell his house that is currently worth USD 250,000. Now, if a buyer comes along but has a bad credit history, he will not be able to pay the down payment on the house. Therefore, he opts for the lease purchase strategy. Both parties mutually agree for an option fee of USD 6,000 and a lease period of three years. And, if the standard monthly rent is USD 1,200, the buyer will pay USD 1,500, where the remaining USD 300 contribute to his down payment. Now, after three years, this contribution will amount to [ 300 * 36 (months) ], USD 10,800. Add this to the initial option fee of USD 6,000, the buyer or tenant will have a total of USD 16,800, which is sufficient enough for a down payment. Now, the house can be owned by the tenant. But, if the tenant does not agree to buy the house at the end of the lease period, he will lose the accumulated down payment, and in most cases, even the option fee will not be refunded.

Benefits

Buyer
  • He may not possess the down payment now, but he will have it at the end of the lease period, as a result of the additional payments.
  • He can improve his credit score by making timely rental payments.
  • If the market price of the house is more than the agreed-upon price, he still gets to buy it for the same amount. If the market collapses and the price of the house falls below the agreed-upon price, he does not have to go through with the deal.
Seller
  • The seller has the advantage of having a tenant who is responsible enough to want to buy the home; who thinks he will own it one day, and therefore, he will take good care of it. This includes responsible repairing, less dirtying of the house, regular maintenance, etc.
  • The rent he receives covers all or a part of his monthly mortgage payment.
  • He can also use a nonrefundable deposit. If, at the end of the rental period, as written in the contract, he is not able to close the sale, it can be terminated (or renegotiated).
  • The monthly rent and option fee will be an incentive for the buyer to treat the home with care and responsibility.
  • The tenant is less likely to quickly move away since he aims to completely own the house one day; and therefore, it gives the seller less vacancy costs. Additionally, if the tenant does move away, the seller has the security deposit as well as the option fee to his credit.

Risks Involved

Buyer
  • If he does not go ahead with the purchase, he usually has to forfeit the option payment, and he stands to lose all the extra money paid over time.
  • There is no guarantee that a bank will grant him a loan when he applies for one. He might still have to improve his credit score or find someone to co-sign his application.
  • He might not qualify for a loan before his option term expires.
  • He does not yet own the property, and the seller might get the property foreclosed.
  • If home prices fall, he might not be able to renegotiate a lower purchase price.
  • If he does not pay rent on time, he may lose the right to purchase (along with all the extra payments).
  • There might be problems with the property that he does not know about until he tries to buy it.

Seller
  • Home prices might fall, and if the tenant does not buy, the seller would have been better off simply selling the property to someone else.
  • He does not get a large lump-sum, which he may need for some other reason.
  • When the tenant opts out of buying the property, he has to start all over again and find another buyer or tenant.

Things to Remember
  • There is a big difference between rent-to-own home and lease option. The latter gives the tenant the option to buy the home. The tenant may not agree to buy it, but if a contract is offered, he may have first right of refusal. In other words, he should produce financing and close on a loan, or make plans to move out. The former is a contract to buy with an extended closing date. The time is used to save a down payment or to line up acceptable financing.
  • Do some background research. Go to the county registry office and get a copy of the owner's title records that mention the actual owner of the property, and the amount of mortgages, if any, registered against title so that you know you are dealing with the correct owner.
  • Ask for a mortgage statement that mentions the outstanding amount on the property.
  • Hire a site inspector and inspect the property thoroughly. If the property is in a dilapidated condition, in which case, you might have to make extensive repairs, it is not worth buying.
  • Register the lease and option agreement against title. This will protect you from future dealings by the owner with the property. Use a lawyer to protect everyone involved by doing the proper due diligence in advance.
  • Take a look at your credit report to clear up any issues or to raise your credit score. Review the report for errors, duplications, and outdated information.
  • Visit a mortgage lender and get qualified for a loan. Even if you do not have bad credit, having a debt ratio may be a hindrance in getting your mortgage approved. This meeting will show the amount of debt you can handle each month and still be approved for a mortgage. Down payments and loan types will be discussed, making you a well-informed future borrower.
  • If the tenant pays an initial deposit towards the final purchase, it should be held in a trust. It is not to be paid to the landlord until the deal terminates.
In all cases, it is important that the parties take legal advice. Some agreements state that if the payment of rent is late even once, the tenant forfeits the right to buy the home. This needs to be changed so that as long as the tenant cures any default in a timely manner, he/she does not lose the right to buy. The tenant should also have the title checked to make sure that the rightful owner of the home is offering the option. Sellers need to make sure that the option payment is covered in a separate agreement, and is not included in the lease. If it is included in the lease and then the tenant defaults, it can be harder to evict the tenant from the property. Home owners or sellers should also carry out a thorough credit and background check, to ensure that the tenant has the means to make all the required payments. This program is a very good option if both parties are interested and properly prepared.
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Published: August 19, 2014
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