Rent to Own: Your How-to for Homeownership
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Fast Facts
Suitable for:
First-time homebuyers and renters
Purpose:
Helps with homeownership through rent
Option fee:
2% to 7% of the home's value
Benefit:
Helps build equity, may not need downpayment
As home prices continue to skyrocket, many prospective buyers are wondering if homeownership is a realistic option. If buying feels out of reach for you, there may be another path worth exploring — rent-to-own.
You may have heard of rent-to-own paths to homeownership before and wondered how they worked. In some cases entering into a rent-to-own agreement can help you realize your dream of homeownership sooner than you expected. But this path to homeownership is not without its risks — and it’s not right for everyone.
In this article
What does rent-to-own mean?
A rent-to-own option allows you to rent a property for a set period of time (say two years) and then enter into a buying agreement at the end of this period. As a buyer, this allows you to get a sense of the home before buying it, while offering the seller monetary compensation in the form of rent in the meantime. In addition, a percentage of the rent is often — but not always — counted towards the cost of buying the house.
When renters enter into a rent-to-own agreement, there are often upfront fees and different requirements depending on the type of agreement entered into to become homeowners.
Types of rent-to-own agreements
There are two types of rent-to-own agreements: the rent-to-own lease-option and rent-to-own purchase-option.
Rent-to-own lease-option
A rent-to-own lease-option agreement, or lease-purchase agreement, allows you to rent the home for the agreed upon amount of time, and then gives you the option to buy at the end of the lease. There’s no requirement to buy or renew your rental agreement, so if you decide you no longer want to live in this home, you can walk away from the deal. This option offers the most flexibility for the buyer, but may come with higher fees.
Rent-to-own purchase-option
A rent-to-own purchase-option agreement lets you rent the home for the agreed upon amount of time, then at the end of the lease term, you’re committed to buying the home, regardless of your financial situation. You can face legal action if you try to get out of this type of deal.
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Fees to consider
In both types of rent-to-own agreements, you’ll be required to pay an upfront, nonrefundable fee. This fee, often referred to as the option fee or option money, can range from 2% to 7% of the home’s value, according to Rocket Mortgage. This fee is paid directly to the seller as a commitment to buy the home at the end of your agreement. It’s often negotiable, as well.
If you enter into a rent-to-buy lease-option and pay a $10,000 option fee to the seller, then decide not to buy the house, you will not receive this money back.
How rent-to-own agreements work
Typically, you’ll enter into a rent-to-own agreement by first deciding on the type of agreement, determining how long the rental period will be, how much the home will cost, and how much of your rent payments will count towards the cost of the home.
First, you should consider if a rent-to-own lease or purchase-option makes the most sense for you and come to an agreement with the seller. While the lease-option could be viewed as safer, since you could walk away, you also risk losing your option fee this way. However, the purchase-option locks you into buying the property, but could come with a lower negotiated option fee.
Once you’ve decided on the agreement type, you and the seller (or your agents) will agree upon a rental term, say two years. Rent-to-own agreement rental terms are typically longer than the standard one year agreement, and can be extended for several years.
After you’ve nailed down a rental term, you’ll decide on the home’s selling price. Since you won’t be buying the home right away, the price you’ll pay will typically be higher than the current value to account for appreciation. Keep in mind, if you enter into a lease-option agreement, the seller might ask for a higher price than they would with a purchase-option agreement.
When you’ve agreed to a sale price, it’s time to hammer out how the rental payments you make will be applied to the purchase of the home. The seller might agree to count a percentage of your payments — say 20% — towards the ultimate cost of the home. So, if you have a rental agreement for two years and pay $2,000 in rent, with a 20% agreement in place, you’ll ultimately have $9,600 in rental credits to deduct from the home’s selling price ($2,000 x 24 months x .20 - $9,600). This rental credit can be used as your down payment.
You should always consult a real estate attorney during this process. It can be difficult to understand all of the terms placed into your agreements, and a lawyer can clearly spell out all of the requirements and stipulations so you can make sure you’re fully aware of what you’re signing.
After the paperwork is handled, you’ll move into the property and begin renting it, making sure you pay your rent on-time each month. Once the rental period expires, you can apply for a mortgage and buy the home. Keep in mind, the paperwork phase can happen in a slightly different order depending on where you live and the type of agreement being made.
Pros and cons of rent-to-own homeownership programs
Entering into a rent-to-own agreement is a serious step that you should never take lightly. Here are some pros and cons to consider when deciding if this step towards homeownership is right for you.
You’ll get more time to prepare for homeownership
If you know you want to buy a home, but aren’t financially ready just yet, a rent-to-own agreement can sometimes make sense. It gives you a longer rental period, allowing you more time to save for a larger down payment and prepare your finances for the homebuying process, including closing costs, property taxes and realtor fees that you don't need to worry about as a renter.
It also gives you time to improve your credit score and pay down debt before applying for a home loan. If you’re expecting a raise, promotion, or bump in business over the next few years, a rent-to-own agreement can offer the breathing room you need in between renting and buying a home.
You start building equity, sooner
If the seller agrees to apply a portion of your rent to the asking price, then you’ll be able to start building equity in your home, even without a mortgage, right away. This may be a comforting thought if you’re deciding between renting and renting-to-own, since you’ll be investing in yourself with this option.
You have a chance to get to know the home
Let’s face it — you can’t really know a home before you move into it. Pictures only tell part of the story, but living in a space is much more revealing. A major benefit of a rent-to-own lease-option is the ability to test out a home before fully committing to the purchase. Although you’ll forfeit your option fee, you’ll have years to settle into the home and figure out if it’s the right place for you and your family .
You may not need a down payment
Since most rent-to-own agreements place a portion of your rental payment into escrow, you may find you have enough saved at the end of your rental term to take care of any down payment requirements. This can be particularly helpful to anyone struggling to figure out how to save for a down payment.
Related: How to Save Money for a New House.
You can’t always change your mind
Of course the biggest risk with a rent-to-own agreement is entering into a purchase-option only to find out you can’t afford the home or get approved for a mortgage. Or, perhaps, you’ve decided this house no longer makes sense for you. In most cases, you’ll be stuck with the initial agreement terms. It can be expensive to get out of the deal — assuming you can — which could lead to significant financial hardship and legal issues.
The purchase price may not be finalized right away
In some cases, the purchase price may not be decided on right away, particularly if you’re renting for two years or more. This means you’ll be agreeing to buy a home for an undetermined price in the future, which is risky, However, there are guardrails you can put into place if you work with legal counsel to ensure your best interests are represented, such as keeping the asking price within a certain percentage of the market value. Of course, it’s hard to predict what will happen to the real estate market, so if prices shoot up, you could be on the hook for a more expensive home than planned.
Your rental agreement may have specific requirements
Typically, when you rent a home, your landlord is responsible for certain upkeep and repairs. However, with a rent-to-own agreement, this isn’t always the case. Your landlord may wash their hands of any maintenance or issues that arise during the rental period. If you’re not prepared to tackle these fixes, you’ll want to negotiate this in your rental agreement or consider a different means to homeownership.
It can be more expensive
When you rent-to-own a property, you could end up paying more for the home in the long run. Your option fee is one of the ways you might spend more than you would if you purchased a home the traditional way. Your option fee is a huge chunk of money required upfront and if you change your mind or face financial hardship, you can’t get this money back. It’s important to consider this before entering into an agreement with a seller. In addition, most rent-to-home rental agreements have a higher-than-market rental price. While some of this money may be used towards your initial home purchase, the rest of that rent will not, and is money out of your wallet.
Lastly, since these agreements require serious consideration, you’ll likely need to pay for a real estate agent, as well as legal representation, which could be costly.
FAQs
How do I find rent-to-own properties?
You can often find rent-to-own properties the same way you would find any home for sale. You can use online listing services such as Zillow or Trulia or work with an agent in your area to find rent-to-own properties that meet your criteria. Even if a home isn’t listed as rent-to-own, sellers who have had a property listed for several months might be more interested in exploring this option with the right buyer. Although you could broach this topic with a seller yourself, it’s always better to have a real estate professional reach out to handle this conversation for you.
Is rent-to-own right for me?
That depends. If you can qualify for a mortgage now and have money saved for a down payment, it could be more affordable to buy, rather than rent-to-own. However, if you know where you want to live and need more time to secure a down payment, a rent-to-own agreement could be a helpful path to home ownership.
Do all rent-to-own sellers charge an option fee?
No. Most sellers will charge this fee, particularly in rent-to-own lease-option scenarios, to protect themselves. However, this fee can be negotiated, and in some cases, eliminated. You should be prepared to pay this fee upfront though, just in case.
The bottom line
Rent-to-own is another option for anyone looking to buy a home, who needs a more flexible approach. This hybrid strategy allows you to slowly build equity in your home while renting it, then lets you buy the house at the end of your rental period.
Rent-to-home programs are not for everyone, though, and are often more expensive thanks to higher rent prices and the nonrefundable option fee. It can also be a risky choice if you change your mind, particularly if you’ve entered into a purchase-option agreement.
Before entering into a rent-to-own agreement, we recommend talking to a qualified real estate agent and lawyer to help protect your best interests.
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Writer
Courtney Johnston is a freelance writer, specializing in finance, travel, and health. She has written for The Chicago Tribune, Benzinga, BestReviews, Mashvisor, Fundera, MoneyGeek, and The Culture Trip. She also teaches writing instruction at the University of Indianapolis. Courtney currently resides in Indianapolis.
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