In a typical home purchase, the sale takes place shortly after the offer has been accepted, and the transaction is completed at closing. Since most buyers don’t have the money to pay cash, a mortgage is usually used to finance the purchase: The buyer puts down a certain percentage of the purchase price (the down payment), then pays the lender in regular installments over a period of time until the balance is paid off in full.
To qualify for a mortgage, however, potential buyers need to have a good credit score and cash for a down payment. Without these, purchasing a home in the traditional way may not be an option. There is an alternative: a rent-to-own agreement. When buyers sign this kind of contract, they agree to rent the home for a set amount of time before exercising an option to purchase the property when or before the lease expires.
Here’s how rent to own works, and when it may be a good choice for someone looking to buy a home.
Rent-To-Buy Pros And Cons
As home prices continue to drop, consumers are taking a harder look at rent-to-buy options, in which potential homeowners commit to a multi-year lease with a future option to buy the property.
In other words, it’s nice to have an out. If property values plummet, the renter can remain a renter until the agreement expires. Should values rise, then the rental payments count toward a purchase of the home within the agreed-upon time period
While this may seem like the perfect wait-and-see approach, it’s not a situation for everyone. Among the factors to consider: your long-term job prospects, credit history, mortgage rates and fee structures.
Here’s how it works: Instead of outright purchasing a property, a potential buyer draws up a contract with a seller in which the monthly rental payments, based on the home’s value and often above going rates, count toward an eventual sale. All rental payments made pay down the principle if the renter decides to exercise the pre-paid option–typically 1% of the sale price–to buy.
The date at which the agreement expires varies by contract but is typically between two and five years. At that point, the renter can choose to buy the home at the original listed price minus the equity he or she has built. If not, then the homeowner has the option to evict them and keep all payments.
Why would a seller concede to such an agreement? Well, it’s not easy to sell a home these days. Last year the National Association of Realtors reported 4.9 million transactions; at the height of the boom, in 2004, 8.5 million new and existing homes were sold. Instead of letting a home sit empty, sellers are looking for any income stream they can tap. Mix in the tight credit market that makes it difficult for anyone still thinking of buying to do so, and it’s easy to understand why this particular brand of transaction looks viable.
“With the tight credit market and stricter down payment requirements, rent-to-own has emerged as a trend for people who otherwise would be home buyers,” says Eric Mangan, spokesman for ForSaleByOwner.com, a real estate listing company. His company has started offering sellers the ability to list a home as rent-to-buy, given what he calls a surge in demand.
Of course, there are pitfalls. If a renter eventually decides not to buy, not only do his rental payments disappear but the premium option fee he has paid for the right to buy also evaporates. In addition, if the price of the home goes down considerably over the next three years, then the renter has been paying a rate based on that amount and will find himself overcharged.
On top of that, many contracts in rent-to-buy situations disallow late rental payments from counting toward an eventual sale. Those with punctuality problems might lose equity.
It’s a complicated deal, and renters should be careful about the terms of their contract, especially elements that allow the seller to terminate the arrangement, such as maintenance of the property, payment times or individual clauses. If the housing market improves and the seller can get more at market than in the renter’s option deal, the seller may want to renege.
“Renters who want this option should go with a reputable broker and a good real estate attorney,” says Anthony Sanders finance professor at Arizona State University. “The incentive for the owner to cancel the option if house prices increase quickly is tremendous.”
Still, it can be a perfect option for an aspiring homeowner. Credit is tough enough at present, and for those with spotted credit histories, it’s nearly impossible to get a loan. Those looking to build equity while improving their credit history will find rent-to-own a strong match.
Which brings up a key point of rent-to-buy contracts: They can be helpful for those sitting on the fence but shouldn’t be utilized by anyone who isn’t serious about eventually buying the home. Rent-to-buy should be made as part of a plan to own a home otherwise, it will end up costing more money in fees and above-market rent payments. Make sure the eventual purchase is driving the decision to enter a rent-to-buy.
“A good rule of thumb,” notes Sanders, is to “separate the rental decision from the purchase decision.”