How Does Renting to Own Really Work?

 In the years leading up to the financial crisis of 2007-08, the renting to own model — in which tenants/buyers have an option to purchase the house or condo they’re renting from their landlord/seller— was mostly offered by individual homeowners. In the years following the crisis, it became a bigger option for tenants as large real estate investment firms bought up foreclosed homes across the country and implemented the renting to own model on a larger scale.

This helped formalize the renting to own model, whereby tenants can have a portion of their monthly rent payments accrue toward a down payment to eventually buy the home they’re renting.

With the renting to own option now available to more tenants to buy a house or condo, many consumers ask: how does renting to own work? To answer that question, let’s review the basics of renting to own.

 

Tenant/Buyer Perspective for Renting to Own

If you’re looking for a place to live, plan to rent today but eventually want to purchase your own house or condo, and don’t plan on moving from the area you’re targeting for rentals, then renting to own could be an option for you. It’s also a good option if you have less than stellar credit and need time to build up good credit history while renting.

Rent-to-own is when a tenant signs a rental agreement or lease that has an option to buy the house or condo later — usually within three years. The renter’s monthly payments will include rent payments and additional payments that will go towards a down payment for purchasing the home. The lease contract will state the tenant’s rental payment, how much of the rental payments accrue toward a down payment, and how much the purchase price of the home will be.

Before you sign a renting to own lease from your landlord/seller, you should get pre-approved for a mortgage at the purchase price stated in the contract or lease to ensure you can afford the home. If you can’t, renting-to-own may not be the right option, because the contract could inflate the rental price slightly to account for the contribution of the rent payment that’s accruing toward your down payment (more on this below).

For example, let’s say you signed a renting to own lease that had your rental payments at $1,450, with $250 per month accruing toward a down payment, and a purchase price of $250,000. This would mean you’d accrue $9,000 over three years to go toward a down payment, which would be 3.6 percent of the purchase price.

Assuming you didn’t save any more money than that during that time, you could buy the home using a 3.5-percent FHA loan. As long as your pre-approval in the beginning of the process determined you could afford this, it might be a good deal.

What if you couldn’t afford this as a home buyer, but you still wanted to rent the home? You must ask the seller if the home could be rented for cheaper without the renting to own option. Usually this is the case, because most mortgage lenders only allow the down payment accrual to be a sum that’s above the local market rent. So in this example, not having a renting to own option might mean your rent is $1,200.

You should always have an attorney look at a renting to own contract or lease, because there is no industry standard template for writing renting to own contracts or renting to own leases. You need to be clear on who’s holding the down payment funds, as well as specific state regulations and tax considerations.

The obvious benefit of renting to own options is that your housing plans are in place all at once. This works if you don’t want or need to move. But if you do want or need to move, renting to own will limit you to that single property purchase option, and therefore might not be worth it.

Rent-to-own is also a good option for people who might have recent credit trouble that they need a few years to repair. Your credit score plays a big factor in the mortgage rate you’ll get, which can make a big difference in your monthly payments. Your credit score also helps determine whether you’re eligible for a mortgage.

Making your lease payments on time can help improve your credit. Just make sure your landlord/seller reports your rental payment data to the major credit reporting agencies. There are many other things you can do to improve your credit score while you’re in the rental period of your lease agreement. Start by requesting your free credit report. Federal law entitles you to one free credit report once a year from AnnualCreditReport.com, a website set up by the three major credit bureaus.

 

Landlord/Seller Perspective for Renting to Own

The renting to own purchase model can be a good option for sellers whose houses have been on the market for some time and they can’t find a buyer for a variety of reasons: Perhaps it’s more advantageous to rent in your area. Or maybe interested buyers don’t have high enough credit or enough of a down payment to qualify for a mortgage. The renting to own option can attract potential buyers by giving them a chance to slowly build credit and pay their down payments over time. Just make sure your potential buyers can have high enough credit to qualify for a loan when it’s time to buy.

If you’re a landlord looking to sell your home and want to give a renter the renting to own model, you’ll need to consult an attorney to draft a contract or lease for you since (as noted above) there are no standard templates for this kind of lease option for sellers.
The two most common benefits to a home owner for selling their house or condo in a renting to own agreement are:

You can lock in the future sale price of your home now, and not have to worry about market fluctuations.
If you’re renting to a tenant who eventually wants to own the home, the quality of the tenant is likely to be much higher, and they will treat the house or condo with more respect.
One drawback of the renting to own selling option is that you might want to sell your house or condo sooner, and if your contract or lease doesn’t allow for you to do so, you could be locked into the terms you agree to with your tenant/buyer. Consult your attorney on how to make this sale provision of your contract negotiable if you need this flexibility.

 

Institutional vs. Individual Landlords/Sellers for Renting to Own

Individual homeowners offering a renting to own option for their leases usually set up contracts for three years. Institutional homeowners (like real estate investment companies) often have two-year lease contracts that can be extended for up to four more years after the initial lease term. This offers more flexibility for tenants/buyers.

Institutional renting to own companies are often publicly traded, so they’re subject to a whole host of regulatory scrutiny, which means they’ll be more stringent about consumer protection. This means your contracts will be very clear about the rules of engagement, who holds the down payment funds, and how disputes are resolved.

Big renting to own companies also have consumer help resources to help you with credit counseling and repair. In fact, some companies required their renters to go through credit counseling. If you need credit help, this might be a great resource for you.

If your credit is perfect, you’ll want to avoid a company with this option, or maybe stick to working with an individual landlord/seller.