All about rent-to-own contracts
Today’s best real estate investors recognize rent-to-own contracts for what they truly are: an invaluable tool that can improve the closing process. How? By offering both investors and home buyers flexibility. At the very least, this grossly underutilized purchasing strategy awards buyers one more way to acquire a home. With that said, it’s in every buyer’s best interest to learn how to set up a rent-to-own contract agreement.
What is a rent-to-own contract?
A rent-to-own contract is a lease agreement between a buyer and a seller. The agreement allows a prospective buyer to rent a property until her or she is able to save up enough money to eventually purchase the home.
Over the course of the contract, the renter will pay more than the fair market value of the property in rent each month. The extra money will be applied to the down payment at a future date. At the end of the contract, the renter will typically have the option to buy the home or walk away.
If they exercise the latter, they will lose out on the extra money they paid each month. However, if they choose to exercise the purchase option, they will need to apply for a mortgage, using the accumulated payments as the down payment.
How does rent-to-own work?
Rent-to-own contracts are initiated once sellers and buyers agree on the terms. Before anything can transpire, the buyer and seller must draft a rent-to-own contract that each party is comfortable proceeding with.
The contract will take the form of either a lease agreement with the option to buy or a lease agreement with a purchase agreement. Once each party agrees on the type of contract, they will then agree on a purchase price.
Often included in the purchase price of a rent-to-own deal is what’s called an option fee. The option fee is paid up front and usually amounts to 1% of the home’s purchase price. This fee will give the buyer the option to buy the home at an agreed upon price in the future. Paying the fee is generally seen as a “good faith” payment, suggesting the buyer is likely to exercise their right to buy the home at the end of the rental period. To be clear, this fee will be applied to the final property purchase if the option is exercised.
The contract will also detail the period in which the property will remain rented. This duration varies dramatically from contract to contract based on each buyer’s personal financial situation. The renter will pay enough money each month to cover the agreed upon rental price as well as additional payments that will go towards a down payment at a later date. As a result, the rental period is usually determined by how much the amount renters are able to pay each month. However, most rent-to-own contracts increase the monthly asking rent payments by 25% to 30%.
Once each party comes to terms with the purchase price, monthly rent and time period, it’s time to define their maintenance roles. Since both parties will have an active interest in the home, the roles can get a bit confusing. Therefore, it’s important to predetermine whether it will be the tenant or the owner who will pay for upgrades, repairs, amenities and utilities.
If each party can agree on terms, the next thing to do is to carry out the contract. The renter will proceed to live in the property for the agreed amount of time, and when the contract is set to expire, they may either exercise their right to buy the home or walk away. If they decide to follow through with a purchase, they will need to apply for a mortgage and follow through with the closing process — using the extra cash they paid in each month’s rent as the down payment. If the renter doesn’t want to buy and their contract doesn’t legally obligate them to make the purchase, they may walk away from the deal. In doing so, however, they will lose out on that extra money they paid each month.
What are the types of rent-to-own contracts?
There are two types of rent-to-own contracts: a lease agreement with the option to purchase and a lease agreement with a purchase agreement.
The first of the two types—a lease agreement with the option to purchase—is the most common. As its name suggests, this contract gives renters the option to buy a home at the end of the rental period (the key word being option).
Therefore, renters are under no obligation to buy when they sign a lease agreement with the option to purchase. If the renter decides to buy the home, they will follow through with the contract and exercise their option to buy. In the event the renter doesn’t want to buy the home, they will simply let the offer expire and walk away from the property.
The latter of the two contract options—the lease agreement with purchase agreement—is less flexible. In fact, renters who enter into this type of contract may be legally obligated to purchase the subject property at the end of the term. Other than the obligation to purchase the home before the contract expires, everything else mimics the first type of contract.
What are the benefits of rent-to-own contracts?
The rent-to-own process has several benefits:
Buyers may acquire a home for much less money up front.
Buyers may apply portions of their rent each month to the impending down payment and purchase price.
The purchase price is entirely negotiable and determined in advance.
Buyers with poor credit may be able to acquire a home they would have otherwise been unable to with a rent-to-own contract.
It's possible to lock in a purchase price in a market with prices that are appreciating.
Buyers may essentially “test drive” the home before they commit to a purchase.
Are there any downsides to rent-to-own contracts?
Due, in large part, to the nature of the real estate industry, every exit strategy has at least some degree of risk, and rent-to-own contracts are no exception. In fact, there are some notable pitfalls associated with the process:
Walking away and neglecting to exercise the purchase option will result in the loss of the money that was spent above and beyond each month’s rent check.
If the renter signs a lease agreement with purchase agreement, they are legally obligated to buy the home, regardless of their situation at the end of the contract’s terms.
Renters don’t own the property until the purchase option is carried out, which means they have less control over the period leading up to the transaction.
There’s always that chance that prices may fall over the course of rent-to-own agreements.
How do I set up a rent-to-own contract?
Rent-to-own contracts are relatively easy to set up, as long as each party agrees on the terms. Setting up a rent-to own contract starts and ends with the contract itself. To get things started, the contract must state whether it's a lease agreement with the option to purchase or a lease agreement with a purchase agreement. That’s an important distinction to make, as it will determine whether or not the renter is legally obligated to buy the home after the contract expires.
Next, the purchase price must be set and agreed on by both parties. At this time, the renter/buyer will pay an up-front option fee. While applied to the purchase price at a later date, this option fee gives the buyer the right to exercise the purchase option.
The two parties will then agree on a rental term, or how long the renter will live in the property as a tenant before the option expires. Before the tenant moves in, the contract must state who will take care of maintenance issues.
Initiating a rent-to-own contract is far less common than most types of home sales, but the process is nonetheless valuable to prospective buyers and can benefit everyone involved. Buyers, in particular, are granted several advantages over traditional mortgages, some of which may even allow them to purchase properties they would have otherwise had to pass on. As a result, every buyer should learn how to set up a rent-to-own contract.