How Does Rent to Own Work? Plus the Pros and Cons!24 Sep Melody Keilig
A rent-to-own home is an agreement that allows a renter to purchase a house after a few years of renting.
With this unique contract, the renter pays more in rent compared to the fair market value. But that extra money then becomes a down payment that goes towards the home. So although the renter may have to pay an "option fee," which is 1-5% of the home's value, it's not always a required payment.
However, if the renter doesn't buy the house at the end of the lease, they will lose their extra payments to the homeowner.
How Does Rent to Own Work?
So how does rent-to-own work? The contracts vary, but typically, the process is relatively the same.
First, the renter agrees to lease a home for a certain amount of time. Usually, this is one to three years.
Second, the renter has to pay a fee upfront which is called an option fee. Usually, 1-5% of the home's purchase price. Although the fee is non-refundable, it can apply to some or all of the renter's down payment.
Third, the renter can pay a higher monthly rent, with a portion of it going into a fund used for a down payment later.
From there, the tenant with the rent-to-own contract locks into the purchase price of the house. They can then buy the home either on or before the lease's expiration date.
What Are the Types of Rent to Own Contracts?
There are two different types of agreements for rent-to-own property agreements. These are known as lease-option and lease-purchase, which both are similar in some ways.
For instance, both agreements allow a renter to lease a home for one to three years to buy at the end of the lease. However, there are some differences between these contracts that are crucial to understanding. So let's explore these various contracts!
A lease-option agreement requires a buyer to pay the homeowner the option fee when they sign the contract. However, because the option fee is not usually absolute, the buyer can negotiate with the homeowner or property management company for a lower fee.
The rent money, also called rent credits, saved over the lease, goes towards the down payment towards buying the home. The buyer can work with the seller on a compromised purchase price after the lease expires. This process usually needs a home appraisal to determine the worth of the home.
Most of the time, the option fee reduces the purchase price of the property. If the renter is not interested in buying the home, they can walk away from the option fee and allow it to expire. But doing so will forfeit the option fee and rent credits acquired.
A lease-purchase agreement will allow a renter to lease the home and put a portion of the rent towards the down payment. But the renter is obligated to buy the house at the end of the lease.
The renter and the seller will agree to a purchase price when the lease is signed. Both parties can also decide on a price before the renter signs the lease. The specific date can be selected for the home appraisal and agree to the price at that time. After both parties agree on the price, the renter can begin their lease.
Setting a price beforehand gives the renter a better idea of how much money they may need for a loan. Selecting a lease-purchase agreement means renters should start shopping around for a loan while the renter is currently living in the home or when they agree on a price.
If the renter cannot get funding for the home by the end of the lease, they will have to give up all of their rent credit and claim to the house.
Lease-Option Vs. Lease-Purchase
Which is the better choice for renters, a lease-option agreement or a lease-purchase agreement? It depends on the real estate market.
When home prices are rising in the market, locking down a specific price for a home will help the renter build more equity in the home over the lease. However, if home prices are stagnant or depreciated, the renter may want to pay for an appraisal at the end of the lease.
What Are the Pros and Cons of Rent to Own?
When it comes to any lease agreement, there are significant pros and cons to weigh when determining whether it's a good option for your specific needs. Likewise, there are several positives and negatives with rent-to-own homes, so consider what you're looking for and see if it's right for you.
The rent-to-own agreement allows renters to build credit and save for a down payment while they build home equity. It also gives them a backup plan if the home value drops or a family member loses their source of income. There are more pros of investing in a rent-to-own home, so let's explore these benefits.
* Rent Is an Investment: In a standard rental, the rent money goes towards the landlord. Whereas with rent-to-own, a portion of the renter's money is an investment into the home. So with each monthly payment, the renter gets closer to owning the home.
* Purchase Is Not Dependent on Credit: Rent-own-homes are an excellent option for renters with not the best credit. Because the monthly rent is going towards purchasing the home, it's similar to a mortgage payment. For example, when the last payment to buy the home is due, the landlord can use the renter's established credit to justify the sale and transfer the deed.
* Quicker Move-in: With a typical home purchase involving a mortgage, it can take months for the homebuyer to move in from the time the offer is accepted. But with rent-to-own homes, the renter can move in within one to two weeks after the final agreement, and any documentation is signed.
* Faster Growing Equity: Compared to the average mortgage, equity builds faster in a rent-to-own home because the appreciation happens much faster. When a tenant is in control of the home, they can make improvements as they pay monthly. When it's time for the final payment, the purchase price might be less than what the home is worth.
* Full Control Over Home: When a renter moves into a rent-to-own home, they have full control over the house. They can make adjustments to the home, including improvements. Because the renters are paying to own the home in the future, landlords typically aren't concerned about tenants damaging the home.
* No Property Taxes (While Renting): Because the home still belongs to the landlord, they are responsible for the property taxes until the homeownership transfers to the renter after the final payment on the home. The renter will save money much easier until they own the home or prepare to pay the purchase price.
For renters and landlords, there are many other benefits with rent-to-own. Although renters pay higher rental costs, they will eventually own the home.
There are also cons with a rent-to-own agreement, including losing the option fee and possibly a portion of their rent used for the down payment. In addition, these agreements could be costly for renters who may benefit more from buying a standard home. But take a look at the disadvantages of rent-to-own to figure out if it's a good choice for your financial situation.
* Higher Monthly Payments: The renter will have a higher monthly payment in a rent-to-own home than a standard rental in the same area. The renter pays extra because a portion of that money is going towards the home's down payment. Although the renter could pay a cheaper rent in another rental, they can own the house at some point if they have the finances.
* Higher Interest Rates: A renter will miss out on the current low-interest rates for mortgages. Because of this, they may receive higher interest rates at the end of their lease.
* Non-Refundable Option Fee: If a renter is not prepared to buy the home at the end of the lease, there's a chance they will lose their option fee and their portion of their rent being set aside for their down payment.
* Financial Penalties for Breaking a Contract: Although some contracts allow a renter to walk away from a rent-to-own home, breaking a lease-purchase contract can result in financial penalties.
* The Home Could Lose Value Over Time: When a renter signs the lease with the intent to rent for a few years, the home could lose value over time. Depending on the market, the house could be worth a lot less after three years of renting, putting the renter at risk of not getting a mortgage if the home doesn't appraise for a high enough price to interest lenders. If the home's value decreases throughout the leasing period, renters may have to pay a higher-than-market price for the home. The loss of value could be an issue later if the buyer decides to sell the home.
* Responsible for Maintenance: Depending on the specific rent-to-own contract between the landlord and renter, both parties might share these costs. But sometimes, repairs and maintenance may be the responsibility of the renter.
* Property Taxes (After Buying): When the renter purchases the home after a few years of renting, they take on the responsibility of homeownership. That includes taking on the property taxes before becoming eligible for tax breaks as the new owner.
Is it Legal to Rent to Own in Texas?
So are rent-to-own properties legal in Texas? The answer is yes!
These rent-to-own agreements are made between the renter and homeowner, where the home is typically leased between one and three years.
The renter may also pay a higher monthly rent while saving a portion to set aside for their down payment. The rent-to-own contract states that the renter will buy the home on or before the date when the lease will expire. While some of these contracts provide the option to purchase the home, others require it.
However, if you want to take the standard homebuying route, Texas can offer many homebuyer programs to residents.
How Much Money Do You Have to Put Down on a Rent to Own Home?
A rent-to-own agreement usually includes an option fee, which gives the renter the option to buy the home at the end of the lease. This fee goes toward the renter's down payment on the home. If the renter backs out of buying, the landlord will not refund the option fee.
There is no standard rate for option fees, but it will typically be between 1-5% of the purchase price. However, the fee is also negotiable, so that the price will vary among contracts.
Who Pays the Taxes on a Rent to Own Home?
The current homeowner is legally liable for all property taxes until the property is closed on. They are also responsible for any HOA fees and homeowner's insurance costs.
With most landlord situations, these costs are passed down to the renter through their monthly rent payments. In addition, depending on the contract, the homeowner will pay for repairs and renovations.
How Do You Calculate Rent to Own Payments?
Because several payments are involved in rent-to-own contracts, it's a good idea to understand how to calculate these costs. If a renter knows how to estimate the amount of money they need to put down on a contract, they can better prepare their finances.
Here's how to calculate each of these payments:
* Option Fee: Because this fee ranges from 1-5% of the agreed purchase price of the home, it can be estimated with a simple formula. For instance, if the home is $400,000, take that number and multiply it by the option fee percentage. So if that's 4%, the calculation will be 400,000 x 0.04, which will equal a $16,000 payment for the renter.
* Monthly Rent: Typically, a portion of the monthly rent on a rent-to-own home is set aside to cover the home's purchase. Sometimes, this means that the payments are higher than a standard rental. The monthly rent cost and percentage credited towards the purchase are stipulated on the rent-to-own contract.
To calculate this cost, multiply the monthly rent by the rent percentage put toward the home. For example, if the monthly rent is $2,000 and the renter has 30% put toward the home, calculate 2,000 x 0.30 (30%). This results in $600 in equity for the home each month. If the contract is a three-year lease, calculate $600 x 36 months. This calculation results in $21,600 that is going towards the home.
* Home Purchase Price: This price is calculated based on the current market rates. As with a home purchase, the buyer has some negotiation power on the home's final cost. However, once the contract is signed, the price is locked in.
Renters must understand the background of these payments before signing a contract, checking their budget to make payments, and save up for the purchase price.
Can You Back Out of a Rent to Own Contract?
Depending on the contract, a renter can back out of the property. However, some rent-to-own contracts require the purchase of the home at the end of the lease. Whereas other contracts give the renter the option to purchase without requiring it, meaning the renter can walk away with no strings attached.
However, this is only when the lease is over. Breaking the lease can result in possible legal and financial penalties for the renter if they back out before the lease is up.
When considering the lease agreement to a rent-to-own home, it's essential to understand the various contracts that can sometimes differ depending on the landlord. Therefore, it pays to know the positives and negatives before signing anything, no matter your final decision.
Depending on the circumstances, a rent-to-own home could work wonders for some but be detrimental to someone else. So read over all of your options and make the right choice for you by being fully informed. For more renting and home buying tips, you can check out BHGRE HomeCity!