How do rent-to-own homes work?
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Following the financial crisis of 2007-08, an alternate method of homeownership, for those who didn’t have the money or the credit score to get a loan, became popular. It was called the rent-to-own model. So, how do rent-to-own homes work? Let’s explore what it is, the pros and cons of renting to own contracts, and whom does it benefit the most?
What is the rent-to-own home model?
In this type of homeownership, the tenant has the option to buy the home or condo they’re renting from their landlord. So, how did this system become popular? Well, right after the recession, large real estate investment firms bought many foreclosed properties across the country and implemented the rent-to-own model on a larger scale.
Renting to buy a house is different from a conventional mortgage – the home buyer can purchase the piece of real estate without going through a bank and can finance the purchase directly through the homeowner or the seller.
However, you need to think of the home-buying process the same way you would treat conventional buying. You need to do your due diligence, look at the neighborhood comp, and research the contract details as well as the seller’s history.
A rent-to-own agreement would typically include the purchase price, the monthly rent, the schedule of the payments, and the term of payments.
Keep in mind that there may be certain risks and downsides to this model – all of which we’ll discuss in this blog.
What are rent-to-buy homes?
Such a rental property includes a clause in the rental agreement that either gives the tenant the option to buy the house or an obligation to buy it after a certain time period. Interestingly, a portion of the monthly rent payments can count toward the down payment. In case the tenant decides to buy the house, the excess money can be used for the home purchase.
Who are rent-to-own homes perfect for?
This concept appeals to people who are keen to own a property but do not have sufficient funds or a sizable down payment. Or, the minimum credit score requirement to secure a good loan. They fail to qualify for a traditional mortgage. Renting to own property can give them sufficient time and strategy toward saving for a down payment and working on improving their credit score. And, if a percentage of the rent goes toward the purchase price, the potential homebuyer also gets to build some equity.
In today’s real estate market too, with staggeringly high home prices, strict automatic underwriting guidelines for loan approval, and high down-payment requirements, many financially capable people are experiencing trouble obtaining financing and may resort to rent-to-own schemes.
What are the different types of rent-to-own contracts?
Lease-option and lease-purchase agreements are the two kinds of rent-to-own contracts. While both options allow you to rent a home for one to three years with the option to purchase it at the conclusion of the lease, there are some contractual distinctions between the two.
When you sign a lease-option agreement, you must agree to give the homeowner an option fee, which normally ranges from 2% to 7% of the entire purchase price.
If you decide to buy the house after your lease is up, you can put the rent savings or rent credits toward your down payment which lowers the property’s buying price. You can negotiate a fair purchase price with the home seller. A home appraisal will help you determine the actual value of the home. If you decide not to purchase the house, you can walk away from the deal. However, that will forfeit your option fee as well as your rent credits.
A lease-purchase agreement and a lease-option arrangement are very similar. Here too, you continue to rent the house for a while and contribute a portion of your rent towards a down payment to purchase the house.
The only difference is that when you sign a lease-purchase contract, you are obligated to buy the property. Both you and the seller determine the purchase price. Alternatively, you might agree on a price and set a date for a home appraisal. You begin your lease after reaching an agreement with the other party.
Establishing a price in advance helps you determine how much cash you’ll need to borrow. That makes it easy for you to begin looking for a loan at the earliest.
However, if you fail to get the funding by the end of the lease, you’ll need to give up your claim to the house and all the rent credit. The homeowner may even sue you for breach of contract.
How do rent-to-own homes work?
You need a formal legal contract to allow a rent-to-own arrangement. The conditions of the arrangement and whether you have to purchase the home or simply have the option to do so should be clear in the contract.
Here are the steps to buying a rent-to-own home:
- Both you and the seller have to agree on the purchase price of the house in question.
- Also on when and how the price is determined – it could be at the time of the contract signing or when the lease expires. And, is based on the property’s current market value.
- You will have to pay rent throughout the lease term, a percentage of which will go toward the eventual purchase price at closing. For example, if the monthly rent is $1,200 and you’ve rented the house for three years (36 months) and have agreed to credit 25% of that amount ($1,200 x 0.25 = $300) toward the home purchase, you’ll have a rent credit of $10,800 ($300 x 36 = $10,800).
- Usually, if the terms of the agreement state so, you will have to be responsible for maintaining the rent-to-own property, even paying for any repairs. In such a case, it’s best to get a renter’s insurance policy to cover any losses to personal property and get liability coverage.
- In most cases, you’ll be splitting repairing responsibilities with the landlord. It’s best to consult a real estate attorney to understand your responsibilities regarding maintaining the property. The charter of duties could include anything – from mowing the lawn and cleaning out the rain gutters to replacing a damaged roof or updating the electrical panel.
- If you have a lease-option contract and want to buy the house, you’ll need financing to pay the seller in full.
- If you have a lease-purchase contract, you’ll be legally obligated to buy the house when the lease expires. And, if you fail to do so, maybe because of financial constraints, you may get sued by the home seller.
What are the pros of rent-to-own homes?
- It allows you enough time to save money for a down payment.
- It gives you a chance to test drive the house before deciding to buy it.
- If you’re splitting repairing and maintenance responsibilities with the seller, you’ll save on repair costs. This is especially an advantage if you don’t have sufficient money to cover large home repairs.
- It offers you the option to either buy the house or move to another property at the end of your lease.
What are the cons of renting to own homes?
- If you choose not to buy the property, you will stand to lose out on money you paid as rent credit to the homeowner. And also the option fee.
- If you don’t qualify for a home loan at the end of the lease, you’ll have to relinquish your right to the house. What’s more, the landlord can put the home up for rent again.
In a rent-to-own agreement, you commit to renting a property for the purpose of buying it or choosing to buy it before the lease runs out. The rent-to-own works on the basis that you pay the house rent out of which a certain percentage goes toward the purchase price.
If you’re eager to own a house but do not have a good credit score to qualify for a mortgage, or sufficient cash for a down payment, this option may be suitable for you.
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