We have a lot of people call us and ask us if we have any “rent to own” properties available. More commonly among real estate agents, we say lease/purchase or owner finance properties depending on what the buyer is truly talking about.
Rent-to-own agreements can seem appealing to potential homebuyers who cannot qualify for a traditional mortgage. However, the terms and potential pitfalls of such arrangements warrant careful consideration. Let's explore how rent-to-own agreements typically work and the pros and cons involved.
Rent-to-own can be a solution for those who cannot immediately qualify for a mortgage but aspire to homeownership. However, it often involves higher costs and significant risks, mainly benefiting the seller. Thoroughly understand the agreement, consult with a real estate professional, and ensure your financial situation is likely to improve within the specified term before committing.
The Basic Structure
1. Down Payment and Purchase Price
- You pay the current owner a down payment, typically ranging from 3%-20% of the purchase price. For this conversation’s sake, let’s say $15,000.
- You agree on the house's purchase price, for example, $350,000.
2. Title Work and Fees
- If you are owner financing: title work is done to put you as the “owner,” while the previous owner becomes the “mortgage holder.”
- You pay the fees to do this paperwork and file it with the county/state as part of your closing costs, unless negotiated that the seller pay a portion of that.
- If you are not owner financing, and just lease/purchasing, down payment is still typical however title does not switch hands until you can purchase it with traditional financing or cash terms.
3. Monthly Payments and Principal Reduction
- Your monthly payment is typically somewhat negotiable, however it is very unlikely that this will be a favorable amount for the buyer/tenant. Typically, we see market rent plus a pre-negotiated amount above market rent to be credited toward the purchase price or final closing costs amount, if any. If the current owner has a mortgage, you may not get any rental credits since your rent has to cover mortgage payments, taxes, HOA dues, and more. This is all decided before a contract is signed.
4. Responsibilities
- In a true owner finance, as the owner, you also pay taxes, utilities, HOA fees, and maintenance.
- In a rent-to-own, the current owner typically remains responsible for these.
5. Term and Balloon Payment
- Both the owner finance option and the rent to own/lease purchase options typically have beginning and end dates. It is not uncommon to see a balloon payment due at the end of an owner finance option, which is when the owner finance is expected to turn into long term finance. You can likely only make this payment if you qualify for a home mortgage loan from a bank or come into some cash.
Risks and Challenges
1. Foreclosure
- If you can’t get a new mortgage for the balloon payment or get behind, the previous owner gets the house back (foreclosure). Your down payment and monthly payment amount is then lost.
- Any maintenance and improvements you made to the home revert to the previous owner.
2. Missed Payments
- If you miss a payment, even by two weeks, the owner can foreclose on you, depending on local laws.
3. Financial Viability
- If you qualify for a loan now, it’s better to buy a house and get a mortgage from a bank.
- If you don’t qualify now, what makes you think you will be able to get a mortgage after 7 years?
4. Other risks for the owner of the property:
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What if the home continues to appreciate in value? You are locked into a contract with the buyer/tenant at a lower price than you know you would get today.
Damage to the property is a valid concern, just like with any rental.
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If you don’t get enough money as a down payment up front and the buyer stops paying rent or moves out, this could negatively affect you in the future. Definitely hire a skilled real estate agent to help you through the process
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What if you’re that buyer and you’re settling for a home you don’t truly like, just because that home allows for this purchase option? That certainly isn’t in your best interests In this instance it may just be better to wait until you know you ready.
When It May Be a Great Idea!
1. Temporary Credit Issues
- If you have temporary issues preventing you from qualifying for a loan (e.g., insufficient industry history, contractor status, commission-based income, or awaiting a bankruptcy removal from your credit report), rent-to-own might be viable.
- It’s essential to be certain you’re only 1-3 years away from qualifying.
2. Owner Financing Without a Mortgage
- The owner becomes your lender, and you pay them instead of a bank. This is highly advantageous to investors to not tie up their existing credit lines.
3. Clear Contracts and Liens
- Ensure contracts clearly state who owns the property and any outstanding debts.
- Have a recorded lien to protect against owners making changes to the property while you don’t own it.
