What is a Rent to Own Home?
REtipster provides real estate guidance — not legal advice.
The information in this article can be impacted by regional legislation and other unique variables. For the real deal, always consult with a qualified legal professional before taking action.
How Rent to Own Works
Rent-to-own agreements have two parts:
- A Rental Agreement
- A Purchase Agreement (or Option to Purchase)
These two agreements can be set up as two separate documents or combined into one.
A Lease Option and Lease Purchase have many similarities and a few important differences.
Lease Option vs. Lease Purchase
Here are the most notable similarities between a Lease Option and Lease Purchase:
- Leases in rent-to-own situations are typically between one and five years.
- Tenants can potentially negotiate to have some or all of their upfront consideration and/or rental payments applied to the purchase price.
- The agreements can be set up as two separate agreements or combined into one.
- Many tenant-buyers and landlord-sellers who enter into this type of agreement have similar reasons for doing so (see below).
However, as the names imply, the differences come into play with the word “Option” and “Purchase”.
With a Lease Option, the tenant can exercise their option to buy the property at a pre-determined price at or before the expiration of the lease term. However, the tenant is not making a commitment to purchase the property. If at the end of the lease term, the tenant is still not in a position to purchase the property or no longer wishes to buy the home, they can simply walk away from the deal (and in doing so, they will also forfeit any upfront consideration and equity they’ve paid toward the purchase price to date).
With a Lease Purchase, the tenant is expected to buy the property at the end of the rental agreement, but instead of closing the transaction within 30 days, the closing will occur several months or years later, with the tenant-buyer renting the property up until the closing date. If the tenant-buyer does not buy the property, they will most likely lose their earnest deposit, any upfront consideration and/or rent credit they have paid toward the purchase of the property.
Similar to a normal purchase agreement, if a buyer is not able to obtain financing for a property, they are typically able to back out of the agreement without any financial consequences (again, depending on how the original agreement is written). However, if the tenant simply chooses not to buy (e.g. – if they have a change of plans or a change of heart), there may be legal ramifications to deal with (i.e. – the seller can sue for failure to perform and/or the seller can keep the earnest deposit, etc).
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How a Lease Option Works
There are many different ways a Lease Option can be negotiated and written on behalf of both parties. However, there are some common rules of thumb that are commonly seen in this type of arrangement.
In a lease-option, there is typically an upfront, nonrefundable option fee or “consideration” paid by the tenant-buyer, between 2% and 7% of the price of the home or the equivalent of 3 to 6 months of rent payments.
In many lease-option agreements, the rent price will be above-market (typically 25% higher than comparable rentals in the area), but a portion of the rent payment may also be allocated toward the tenant-buyer’s down payment if they choose to buy the home.
In a lease-option agreement, the landlord-seller continues to pay for all the holding costs of the property (property insurance and property taxes, etc). In some cases, the tenant-buyer can agree to pays for repairs, maintenance, and utilities or simply pay a higher rent amount of offset these costs for the benefit of the landlord.
In most lease-option arrangements, if the tenant-buyer doesn’t buy the home at the end of the lease period, they will lose their option consideration and any money they would’ve saved on the down payment. This depends on the specifics of how the lease-option agreement is written, however, which underscores the importance of both the tenant-buyer and landlord-seller having their respective attorneys prepare or review the agreement before signing, so both parties are fully aware of the terms and consequences detailed in the agreement.
How a Lease Purchase Works
There is a similar rent-to-own arrangement called a “lease purchase”, which is similar to a lease-option, but the major fundamental difference is that a lease-purchase requires both parties to close on the sale, whereas in a lease-option deal, the tenant-buyer simply has the option to complete the transaction and the seller does not.
Many of the same attributes apply to a lease-purchase agreement
- 1 to 3 year rental agreement
- Upfront option fee paid by the tenant-buyer
- Above-market rent, with a portion going toward the eventual purchase price
- Tenant-buyer pays for utilities, repairs and maintenance
One easy way to think of a lease-purchase is like a 3-year closing deadline, with the buyer renting the property prior to the closing date. The tenant is essentially committing to buy the property at the end of the lease period. If they do not, they will most likely lose their earnest deposit and any money they’ve put toward the purchase of the property. The landlord-seller could also have grounds to sue the tenant-buyer for failure to perform (again, depending on the expectations laid out in the original lease-purchase agreement).
It’s also worth noting, the grounds for a tenant-buyer losing their option consideration or earnest deposit essentially boils down to what is written in the original agreement. For instance, in most purchase agreements, a buyer will not lose their earnest deposit if they are unable to obtain financing approval. However, if they choose not to close simply because they’ve had a chance in heart, then they would lose their earnest deposit.
In any case, it underscores the importance of seeking legal counsel and thoroughly understanding what is written in the lease-purchase agreement, so there are no unwanted surprises for either party in the end.
Why Would a Tenant-Buyer Use a Rent-to-Own Agreement?
There are a few reasons why a tenant-buyer might consider entering into a rent-to-own agreement with a landlord-seller.
- Advantage #1: If a buyer cannot qualify for financing today due to a poor credit score or insufficient income, but they think they will quality before the rental period is over, a rent-to-own agreement will give them the option to purchase the property after they’ve had a chance to improve their credit and income.
- Advantage #2: A lease-option allows the tenant-buyer to get very familiar with the property and its surrounding neighborhood before they make a much larger financial decision to buy the property (note: a lease-option allows the buyer much more flexibility in terms of if/when they will make this purchasing decision, whereas a lease-purchase requires that the tenant-buyer close on the deal).
- Advantage #3: In a rent-to-own scenario, the tenant-buyer is able to get familiar with the property without owning it. Since the tenant is not the owner on title, they are able to avoid some of the additional burdens and expenses that come along with property ownership (i.e. – hazard insurance and liability insurance, property taxes, etc).
- Advantage #4: Depending on how the rent-to-own agreement is written, some or all of the tenant-buyer’s upfront option fee and rent payments may be allocated toward the down payment or eventual purchase price of the property. This effectively allows the tenant to build equity in the property during the term of their lease, as a sort of ‘forced savings’ mechanism.
There are also some disadvantages for a tenant-buyer in a rent-to-own arrangement:
- Disadvantage #1: In many rent-to-own arrangements, the tenant is required to pay money upfront for the right to purchase the property and an above-market rent amount each month during the term of the lease. Unless they can negotiate otherwise, they’ll have to put more money on the line than they would in a normal rental agreement (i.e. – one that does not give them the option to purchase). If the tenant chooses not to purchase the property in the end, they’ll often end up losing more money than if they had simply signed a normal rental agreement without the option to purchase.
- Disadvantage #2: If the value of the property goes down after the tenant signs the initial lease-option or lease-purchase agreement, they will be stuck with an above-market purchase price, unless, for instance, the original rent-to-own agreement gives them to right to revise the purchase price based on an updated appraisal.
While there is certainly a time and place for a tenant to seriously consider a rent-to-own agreement, it also sets up certain limitations and restrictions for both parties that may not be optimal in the end.
Why Would a Landlord-Seller Use a Rent-to-Own Agreement?
There are also a few reasons why a landlord-seller might consider entering into a rent-to-own agreement:
- Advantage #1: In many rent-to-own scenarios, the landlord is able to collect an above-market rent amount for the duration of the rental agreement. While a portion of this monthly rent amount may also be applied to the eventual purchase price, it can increase the landlord’s cash flow up until the property is sold to the tenant-buyer.
- Advantage #2: Most tenants in a rent-to-own situation tend to take better care of the property during their occupancy because they have the mentality of an owner, rather than a tenant. This bodes well for the landlord, and there is a lower likelihood that the tenant will inflict the same level of wear and tear on the property.
- Advantage #3: While the standards for rent-to-own contracts can vary by state, in many cases, the contract may be negotiated so that the tenant-buyer is responsible for paying the cost of utilities, maintenance, and upkeep, which further improves the landlord-seller’s cash flow and greatly reduces the property management burden.
- Advantage #4: If the tenant does not follow through with purchasing the property, the landlord is able to keep the upfront option consideration and rent payments they collected from the tenant along the way.
Of course, there are some drawbacks for the landlord-seller as well:
- Disadvantage #1: If the value of the property rises substantially during the term of the lease, the landlord-seller is still obligated to sell the property at the pre-determined price in accordance with the original agreement.
- Disadvantage #2: If another buyer comes along during the lease term and offers to buy the property sooner and/or at a higher price, the landlord-seller is obligated to comply with the original rent-to-own agreement.
In most cases, if the landlord’s intent is to simply liquidate their property, it’s in their best interests to make the contract shorter (6 – 12 months), and if the landlord’s intent is to collect more money and cash flow from the property, it may be in their best interests to make the contract longer (3 – 5 years).
Problems with Rent-to-Own Agreements
If someone is planning to participate in a rent-to-own agreement (either as a tenant-buyer or a landlord-seller), there are a few things to be aware of:
Unscrupulous Landlords: There have been documented cases of landlords who have taken advantage of their tenant-buyers because of the fact that they can charge above-market rent and keep the upfront option consideration. Some landlords might look for any feasible reason to evict their tenant-buyer before the landlord is obligated to sell the property. Why? Because if they can regain control of their property, they can find another tenant-buyer who will also pay above-market rent and an upfront consideration. With this in mind, it’s important for any potential tenant-buyer to be aware of their rights and perform in accordance with the rent-to-own agreement to avoid any potential loss in a rent-to-own arrangement.
Low Success Rate: Statistically, there are many rent-to-own agreements that don’t result in the tenant buying the property. If a tenant-buyer pursues a rent-to-own agreement because of their low credit score or insufficient income, there’s a good chance their situation won’t actually improve to the point of getting mortgage approval during the 1 – 5 year term (even if they think it will).
In other cases, there can be changes in the tenant’s employment or other common reasons for a tenant to move. For many potential reasons, it’s not uncommon for tenant-buyers to walk away from the property before purchasing it.
Is Rent-to-Own Right for You?
Rent-to-own homes are a good solution for some people, but there are certain complexities involved that aren’t an issue in either a standard purchase agreement or a standard lease agreement.
If you’re considering a rent-to-own agreement as either a landlord-seller or a tenant-buyer, seek legal counsel, make sure the rent-to-own agreement is written in a way that makes sense for you and get educated about any potential consequences of your failure to perform.
It’s also helpful to realize, rent-to-own agreements can have significant variations. Most aspects of a rent-to-own agreement are negotiable, so be your own advocate and make sure the terms work to your benefit in the end.
Reviewed by Claude Diamond, J.D.
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