TL;DR
- When you rent-to-own a home, you are renting a home, but your rental contract will include a special clause that can give you the option to buy the home
- Renters should beware potential “rent-to-own” scams, like homes advertised by people who don’t actually own them or offered for purchase prices far higher than the market value.
- There are two types of rent-to-own agreements: lease-option contracts, which give you the option to buy a home at the end of your lease, and lease-purchase contracts, which require you to buy the home.
It can be hard to know when the right moment to go from renter to homeowner is. That transition entails a whole lot more responsibility, not to mention the financial hurdle of a down payment.
Some renters who are ready to settle down, but aren’t quite ready to make the leap into owning a home, opt for rent-to-own agreements.
But while this type of arrangement might offer some renters an unconventional path to homeownership, anyone considering renting-to-own should be wary of possible scams, as well as the potentially serious financial downsides if they back out of a rent-to-own contract.
What is a rent-to-own agreement?
When you rent-to-own, your rental contract will include a special clause that can give you the option to buy the home after renting for a certain period of time. In some cases, the contract may obligate you to buy the home down the line.
Why would someone want to rent-to-own instead of simply renting and then looking for a different home to buy once they’re ready?
This process can be a bit more friendly to those who struggle to qualify for a mortgage loan. You can spend the time you’re renting working towards improving your credit score, saving for a down payment, and improving your financial situation so you’re a better risk for a mortgage lender. At the end of your lease agreement, you’d still need to qualify for a mortgage in order to purchase your home.
Lease-option contracts vs. lease purchase contracts
If you have the option to buy the home when the lease expires, this is known as a lease-option contract.
These contracts offer a bit more flexibility, since you aren’t obligated to purchase the home at the end of your lease.
If you are required to buy the home, then you have a lease-purchase contract. Got it? Good.
Until that clause kicks in, you make monthly rent payments like you would under a normal rental agreement. This is where things get interesting—some of your monthly payments can count towards your down payment if you choose to buy the home at the end of the rent-to-own agreement (as long as this is specified in your lease agreement, which you should read very closely).
Why would a landlord consider a rent-to-own contract?
A rent-to-own agreement can make it easier for renters to buy a home for the first time. But the homeowner (i.e., the landlord) also benefits.
The homeowner gets to charge a one-time fee (typically called an option fee, option consideration, or option money) that is usually nonrefundable. Paying this fee gives the renter the option to buy the house one day. If you’re in this type of agreement, you can try to negotiate the fee, but you can generally expect to pay between 1% and 5% of the home purchase price.
How a rent-to-own contract works
You can’t rent-to-own without a legal contract in place. You need a contract that specifies any terms of your agreement and whether you have a commitment to make a purchase at the end of the lease or if you can choose to walk away.
You will also want to make sure your contract details the following:
- Choice of purchase price and timing of pricing. You can set a purchase price at the beginning of the lease, or you can do so once it expires. When you choose a price at the beginning, usually it’s above market value, to account for the likelihood that the home value will rise along with the housing market over the coming years. If the seller chooses to set the price at the end of the lease term, they’ll typically base the price of the home on its current market value.
- How you plan to apply rent to the principal. When you rent-to-own, it’s possible to allocate a portion of each rental payment towards your down payment on the home. This isn’t required, but if you do want to do this, you need to determine what percentage of rent payments will go towards the principal of the house.
- Who is responsible for maintenance. Usually when you rent, maintenance and repairs are the responsibility of the landlord, but with rent-to-own agreements, these responsibilities may be the renter’s.
So, what happens if you decide not to buy the home or fail to secure the necessary financing? If you have a lease-option contract, you can choose to move out when your lease ends. At this point, you’ll most likely need to walk away from your option money and any credit towards the house you earned with your rent payments. Oof.
But if you have a lease-purchase contract, you’re contractually obligated to pay the seller in full (this can be in cash or with a loan from your mortgage lender). If you can’t make the necessary payment, it’s best to contact a lawyer at this point to discuss your options.
Pros and cons of rent-to-own
Not sure if a rent-to-own lease is the right fit for you? Here’s some advantages and disadvantages worth considering.
Pros of renting to own
- Makes saving for a down payment easier. Many rent-to-own leases make it possible to allocate a portion of your monthly rent payment towards your down payment, making it easier to save for a home purchase. You may pay more each month than a normal renter would, but this arrangement can help keep you meet your savings goals.
- Gives you time to build your credit. If you’re struggling to qualify for a mortgage because you have a bad credit score, a rent-to-own lease gives you time to improve your credit.
- No need to move! Once your lease term ends, you get to stay put.
Cons of renting to own
- Scams abound. From people who post ads for “rent-to-own” homes they don’t own, to wildly inflated purchase prices, to undisclosed structural and maintenance issues, rent-to-own scams are an unfortunate fact of life. Confirming who owns the property, carefully reading your contract, and getting a home inspection can help prevent you from falling victim to a scam, but given the risks, many renters opt to buy a home the traditional way or continue renting instead.
- You can lose money if you walk away. Even if you have a lease-option contract that gives you the choice to not buy the home at the end of the lease, you typically forfeit the money you paid towards the option fee, and any rent money that could have gone towards a down payment.
- You still have to qualify for a home loan. Unless you save up enough cash to make an all cash offer, you will still need to qualify for a mortgage loan to buy the home. Failing to qualify for a loan can make things really difficult if you have a lease-purchase contract.
- You may be responsible for maintenance and repairs. Double check your contract carefully to see which party is responsible for any property repairs or maintenance—unlike traditional lease agreements, it’s fairly common for these costs to fall on the renter.
Renting to own and your insurance
Since you’ll sign a rent-to-own contract with the intention of becoming a homeowner, you might wonder about which insurance policy is right for you. As long as you’re still renting your home, even if you have a rent-to-own agreement, you’ll want to purchase renters insurance.
The takeaway
While a rent-to-own agreement could potentially make homeownership more attainable, renters need to be careful. If you’re going the rent-to-own route, a lease-option contract is the most flexible option, as it gives you a chance to walk away at the end of their lease if that’s what you want to do.
You may well decide that neither the traditional path to homeownership, nor renting to own, makes sense for you. That’s fine! While you won’t be building home equity, there’s still plenty you can do to build your nest egg.
Regardless of which type of lease agreement you sign, renters insurance provides priceless peace of mind to keep your stuff safe—and with Lemonade, you can get covered in as little as two minutes.
A few quick words, because we <3 our lawyers: This post is general in nature, and any statement in it doesn’t alter the terms, conditions, exclusions, or limitations of policies issued by Lemonade, which differ according to your state of residence. You’re encouraged to discuss your specific circumstances with your own professional advisors. The purpose of this post is merely to provide you with info and insights you can use to make such discussions more productive! Naturally, all comments by, or references to, third parties represent their own views, and Lemonade assumes no responsibility for them. Coverage may not be available in all states.
