A rent-to-own agreement is a legal arrangement in which a renter leases a home from the owner for a designated period of time with an option to buy it before or when the lease expires. Rent-to-own agreements consist of two parts: a standard lease agreement and an option to purchase.
The process of selling a property with a rent-to-own agreement isn’t overly complex, but landlords should learn how it works before engaging in this type of contract.
Having everything in place according to legal requirements is essential to facilitate a lease-to-own home purchase. Being well-versed in what to expect will help you avoid misunderstandings and problems in enforcing the agreed-upon details of a lease-option agreement with your renter/prospective homebuyer.
The Ins and Outs of Rent-to-Own Agreements
A rent-to-own deal can be a winning combination of a rental agreement and real estate sale for the landlord and the homebuyer alike. But if you don’t have a full understanding of lease-to-own guidelines and how to make rent-to-own work as a purchase option, the procedure can turn into a legal nightmare.
But don’t worry! We’ll start with the basics: the different types of rent-to-own agreements.
Lease-Option vs. Lease-Purchase
The most common rent-to-own contracts are lease-option agreements and lease-purchase agreements.
The main difference between a lease-option agreement and a lease-purchase agreement is that the lease-option agreement only forces the seller to sell the property at the end of the lease term. The buyer can walk away in most cases, only losing out on the monthly rent payments made and the often-nonrefundable option fee, which grants their exclusive purchasing rights. The option fee is typically 2-7% of the home’s value, and paying it grants the renter the option to buy the property when the lease ends.
On the other hand, a lease-purchase agreement requires both parties to proceed with the sale terms when the lease ends, unless the contract has been breached by one of the parties.
According to a Forbes post, here are the top six traits of the ideal rent-to-own tenant:
The ability to pay
The willingness to pay on time
A positive long-term outlook for job stability
Cleanliness and housekeeping skills
An aversion to crime, drugs, and other illegal activities
Prospective rent-to-own tenants might be interested in the process, for a variety of reasons, including:
Their inability to secure mortgages from a conventional lender in expensive, non-conforming loan markets.
They’re tired of paying exorbitant monthly rental payments – yet they aren’t sure a conventional loan is right for them.
Setting the Purchase Price
Rent-to-own agreements must clearly explain when and how the property’s purchase price will be determined. The tenant and landlord can agree on a purchase price when the contract is signed, but they may wait until the lease term ends to establish pricing based on the housing market value.
Often, the purchase price for a lease-to-own property is higher than the current market value if it’s set before the lease ends. In some cases, the monthly rent will also be higher than the current market value, and that extra money (or “rent credit”) could contribute to the buyer’s down payment or the principal purchase price at the end of the lease.
How Does the Rent-to-Own Process Differ From Typical Renting?
Beyond the option fee (or upfront fee, as it’s also known), much about the rent-to-own process is similar to typical renting. After screening your prospective tenant to check their criminal, eviction, and credit history, you’ll discuss what kind of rent-to-own agreement works best for both parties. The prospective tenant may request a home inspection before signing the lease if you’re pursuing a lease-purchase agreement.
However, when it comes time to draft your lease, you may want to include addendums to address who pays the property tax, maintenance costs, and insurance fees. Additionally, rent-to-own lease agreements are typically longer term than an average lease, ranging from one to five years.
When the Lease Ends
What happens when the lease ends depends on the type of rent-to-purchase agreement involved.
In a lease-option agreement, the tenant will shop around for mortgage interest rates before the contract ends so they can use the mortgage to pay the seller in full. If the tenant decides not to buy the house, or can’t secure financing, they simply let the option expire.
The tenant would then move out of the home, just as they would any other rental property, and likely forfeit any money paid up to that point.
In a lease-purchase agreement, the tenant and landlord are both expected to proceed with the real estate sale – unless the tenant can’t qualify for a mortgage. In some cases, the tenant will still be on the hook to purchase the property, even if they can’t afford to do so. If the purchase can’t be made and the tenant is allowed to walk away, they’ll forfeit all money paid, including fees and additions added to the monthly rental payments to facilitate the potential home purchase.
The Benefits of Rent-to-Own Agreements
A rent-to-own home is a special type of agreement that allows a tenant to buy a home after a few years of renting.
Benefits of rent-to-own agreements for landlords include:
- Being able to sell the property without paying a real estate agent’s commission of approximately 6% of the sale price, in most cases.
- Very little risk is faced by the landlord in a rent-to-own agreement since the regular terms of the lease still apply. The tenant remains responsible for any damage caused and for all monthly payments, which will likely be of higher value than those of a regular rental agreement. If the tenant fails to purchase the property at the end of the lease term, the landlord typically keeps all the money that the tenant has paid in most cases.
- A rent-to-own deal gives a landlord a way to liquidate properties in less-than-ideal real estate market conditions. For example, if a property is in a less sought-after location, it could sell more quickly and less expensively as a rent-to-own property than by hiring a REALTOR® to sell it via conventional means.
Three primary advantages of rent-to-own agreements for tenants are:
- The fact that they offer people who might otherwise have difficulty building credit and becoming homeowners.
- In some cases, tenants are actually able to build equity while they are still renting.
- If their financial situation changes for the worse and can’t get a mortgage when the lease end, they are not obligated to purchase the home in lease-option agreements. They will likely lose all the money they paid to that point, but they won’t need to go through the stress of foreclosure.
Offering a rent-to-own property can be a wise move, particularly for those with multiple properties in their portfolio.
The Downsides of Rent-to-Own Agreements
If the process goes as planned, rent-to-own agreements can be very profitable for landlords – but they’re not without risk. Here are three top things that can go wrong:
The renter doesn’t end up making the purchase.
The tenant may have trouble meeting the higher cost of the regular monthly rental payments.
Just as is the case with any tenant, the property may need routine repairs. And the renter may cause damage and fail to initiate repairs.