How Rent-to-own Homes Work

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Introduction to How Rent-to-own Homes Work

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A rent-to-own offer in an Illinois subdivision, March 2008. See more real estate pictures.

You've just bought the home of your dreams, signed the contract and packed the moving van -- you're all set, right? Not if you haven't sold your current home first. So you put it on the market and you wait. And wait. And wait. Buyers come along, but they don't have enough money saved up for a down payment, or their credit isn't good enough. How will you ever sell this house?

For many, the rent-to-own home may be the best option. Also called a lease-to-own house, the process works similar to a car lease: Renters pay a certain amount each month to live in the house, and at the end of a set period -- generally within three years -- they have the option to buy the house. Each month of rent they pay is income for the seller, while a portion of it goes toward a down payment on eventually buying the home.

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ннBoth renters and sellers need to be very clear about the contract they draw up before they agree to this arrangement. Renting to own has advantages and disadvantages for both parties. Sellers who have already bought a new house will have relief from paying two mortgage payments at once, and in a slow housing market with many homes for sale, this may be their best option. Buyers who can't yet afford a house may be able to get one more quickly.

Read on to find out how the rent-to-own process works, and after three pages, you’ll have the option to buy this article.

Process Involved in Rent-to-own Homes

So your house has been up for sale for months, and you can no longer afford to make mortgage payments on both your old and new houses. You're desperate to sell but don't want to lose money. Now may be time to consider making your old home a rent-to-own property.

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A sign advertises a reduced price in front of homes for sale April 29, 2008 in Stockton, Calif. When homeowners are eager to sell after having the house on the market for a while, renting to own may be their best option.

Before entering into an agreement, sellers have to decide the sale price and rent they'll charge for the house. Both amounts are subject to negotiation, just as a regular sale would be. But sellers and buyers need to remember that once they sign an agreement, the sale price of the house is locked in until the end of their rental term, between one and three years. Even if other housing prices rise or fall during that time, the original agreed-upon sale price is final.

What's in a Name

There used to be a distinction between a lease-option arrangement and a lease-purchase deal. Lease-option meant that at the end of the term, renters didn't have to buy the house. They were contractually obligated to buy it in a lease-purchase deal --- whether or not they could afford it. People now use the terms interchangeably, so be clear on what contract you sign [source: McLinden].

Renters also have to pay an option fee and then a rent premium. The option fee is a set amount that the renter pays the seller. If, at the end of the lease period, the renter buys the house, the option fee becomes part of the down payment. If the renter doesn't buy the house, the option fee becomes income for the seller. Rent premiums are an amount slightly above the typical rent, with a portion of that money going toward a down payment.

Here's a typical example: The house is worth $200,000, and typical rent would be $1,000 a month. Someone who's renting to own might pay $1,200 a month in rent and then receive a $400 rent credit each month. Add the option fee, in this case $5,000. On a three-year lease, the renter would earn $14,400 in rent credits. Adding the earned rental credits to the option fee, the renter has accumulated $19,400 for a down payment.

This is a valuable alternative for buyers who otherwise wouldn't have the credit score or money saved to acquire their own home. And the sellers, eager to relieve themselves of the burden of the old home, earn this money whether or not the house sells once the leasing period expires. If, at the end of the contract the renter can't or chooses not to buy the house, the seller keeps all of the money.

As with any business contract, there are mutual risks and disadvantages involved for both parties. What if someone else wants to purchase the house for a higher price than originally negotiated? Who's responsible for fixing the leaky roof in the middle of the night? Read on to discover the advantages and disadvantages for each side.

Advantages and Disadvantages of Rent-to-own Homes

For many people, a home will be the biggest purchase they ever make. Both buyers and sellers should carefully weigh their options before agreeing to any binding contract.

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A foreclosure sign sits in front of a home for sale in California.

Let's look at some of the advantages and disadvantages for buyers.

Buyers have time to build income and repair their credit history as they rent the house.
Depending on the agreement, renters can walk away if they find something seriously wrong with the house. Although the renter will lose the option fee and all of their rent credit money, that amount will be much less than if the renter had bought the house outright and then tried to leave it later.
Buyers still have to pay the upfront option fee. It's usually a percentage of the agreed-upon selling price of the home and is often thousands of dollars. Although this money will go to the down payment should the renter decide to buy the house, it can still be difficult to accumulate that much money before renting.
If the buyer is just one day late on a month's rent payment, most agreements void the rent credit for that month. Think about the previous example, where the three-year renter received a $400 rent credit each month. If the renter were late just three times each year, at the end of the lease period the renter would have $3,600 less for the down payment. Rent-to-own leasers must pay on time, every time.
All of those repairs that used to be somebody else's problem in a rented apartment often become the responsibility of the new buyer, even during the rental period. Whether it means climbing on a ladder to unclog the gutters or having to pay for a new washing machine when the original washer breaks, the renter has to take care of it.

Know the Market

Buyers, whether they are buying outright or renting to own, need to do their homework. Sellers often know the market better, so buyers should do research before negotiating a selling price.

And what about the sellers? Here are some pros and cons they can expect:

If home values are falling, sellers can lock in a higher price at the start of the agreement.
Renters who are looking to own generally treat their living space and community better. They're planning for their future, instead of living in a place they will vacate in a year.
If a renter does back out at the end of the agreement, the seller still has the option fee and rent premiums as income. However, the seller is back to square one, which may be difficult for some homeowners who just want to be free of their old house.
If a new potential buyer comes along who wants to purchase the house for a higher price, the sellers are out of luck. They entered a contract with the renter, and they have to abide by it.

Many sellers use the rent they earn to pay the existing mortgage on their old home, which eases their financial burden. If the renter can't make payments, few sellers can afford to pay both their old and new mortgages, which could force them into foreclosure.

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