Rent-to-Own: A homebuying option with no down payment required

Before the financial meltdown of the last decade, getting a mortgage was often surprisingly easy. In some cases, you could buy with no money down.

Of course, we all know where that led us.

Mortgage-lending standards have gotten a lot stricter since then. On the one hand, that’s a good thing, because that “no money down” stuff was never a good idea.

On the other hand, many of us who want to buy a house have found ourselves delaying the home purchase due to these tougher lending requirements.

Perhaps you don’t have enough saved for a down payment. Or maybe you’ve changed jobs a few times and the lack of employment longevity disqualifies you from a traditional mortgage. Or maybe your credit score is not great and the interest rate you’re offered isn’t as low as it could be if you had more time to build your credit history.

Are your dreams of homeownership dashed? Well, not necessarily…

There's an option that’s becoming more common these days. And it can be a great solution for both homebuyers and sellers in the right situations.

“Lease-to-own,” “rent-to-own” and “lease with option to buy” all refer to the same thing: a home purchase arrangement in which the buyer agrees to lease a property for a set amount of time before exercising an option to purchase it for a specified price.

Market research published at the end of 2022 shows that the $10 billion rent-to-own industry is projected to grow over the next five years to be worth over $15 billion by 2027.

But is this scheme all it's cracked up to be? Let's take a look…

How rent-to-own typically works

Rent to Own is marketed as a way to transition to homeownership without having to clear the hurdle of affording a down payment. While this option has more moving parts than a traditional mortgage, it’s not difficult to understand. It works like this:

You find a home that you’d like to purchase on a rent-to-own agreement from an owner who is willing to sell their property on those terms. You and the seller agree on:

1. the monthly rental fee,
2. the length of time you’ll rent before buying, and
3. a purchase price based on fair market value.

You pay an upfront option fee. This is a deposit on the property and gives you the option to buy the home. The fee, while negotiable, is typically 3% to 5% of the agreed purchase price. If you end up buying, the option fee is credited toward the purchase price of the home.

You negotiate and commit to a purchase deadline, typically two to five years, before which time you agree to purchase the home. You make monthly rental payments that consist of the fair market rental value plus an agreed additional amount, commonly called a rent credit, which is credited toward the purchase price of the home.

Let’s say, for example, the owner could rent the home for $1,500 a month. When negotiating the Rent to Own contract, you and the homeowner might agree that you will pay $1,750 a month, with $250 set aside as your rent credit amount. If you have a three-year lease, you’ll end up with $9,000 ($250 x 36 months) in rent credit when the lease ends. You then exercise your option to buy and that rent credit is returned to you at settlement. You can use it as your earnest money deposit or down payment or to pay closing costs.

In a rent-to-own transaction, you'll typically sign two documents:

1. a standard Rental Lease Agreement, which details the monthly rent and terms of leasing the property before you buy, and
2. an Option to Purchase Agreement, which details all the purchase terms. These terms include the price you agree to pay for the home if you decide to move forward with the purchase, the timeframe for you to purchase the home, the amount of your rent credit and the upfront option fee.

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Advantages for rent-to-own buyers

Minimum out-of-pocket cash needed

Instead of a down payment, which is typically 20% of the home’s purchase price and paid to the mortgage lender, the buyer pays a one-time option-to-buy fee, which is typically just 3% to 5% of the purchase price and paid to the seller.

Locked-in purchase price

In a rent-to-own agreement, you are locking in an agreed purchase price. If the property value appreciates during your lease, the seller must sell the property to you at the agreed price. This could be a big discount in growing markets.

Start building equity immediately

One of the major benefits of a rent-to-own is the possibility of building equity without having to put down a sizeable down payment or having credit to qualify for a home loan.

If the home value appreciates from your agreed purchase price, you have immediate equity when you purchase the home. For example, if your purchase price is $180,000 today and the home is appraised at $200,000 in two years when you exercise your option to buy, you have $20,000 of built-up equity. And that’s on top of your upfront option fee and the rent credit you’ve accumulated that go toward your purchase price.

Rent money is working toward purchase

Every month, a portion of your rental payment (typically $100 to $500) is credited toward your down payment, purchase price or closing costs.

Delayed closing costs

On a $200,000 home, your closing costs as a buyer will typically be between $4,000 and $7,000. These costs are incurred when you actually purchase the home. So in a Rent to Own deal, you will have more time to save to cover all of these fees.

Time to improve credit rating and qualify for a lower interest rate

The higher your credit score, the lower your interest rate may be. That’s because a borrower with a very high credit score is less of a risk for a lender. If by waiting to purchase you can improve your credit from fair to good or good to excellent, you could save thousands, even hundreds of thousands, of dollars over the life of a 30-year mortgage by qualifying for a lower interest rate.

Qualification much easier (credit problems are often okay)

Mortgage lenders have strict guidelines to determine whether you qualify for a loan, including:

• your credit score,
• the size of your down payment,
• a debt-to-income ratio of no more than 36% (which means that what you owe on your credit cards, car payments, student loans and mortgage total only around a third of your income), and
• employment longevity at the same company.

But in a rent-to-own transaction, you will be approved at the sole discretion of the owner/seller of the property.

No property taxes

Since you do not own the home (yet), you will not have to pay property taxes while you’re leasing the home.

Quick move-in time

You can typically take possession of the home in a week or two, instead of conventional move-in times of one to three months after your offer is accepted. That’s in large part because your approval will be decided by the owner/seller instead of a lender who often takes 45 to 60 days to approve and process your loan.

Opportunity to avoid paying PMI

Private mortgage insurance (PMI) is a special type of insurance policy that is paid by the borrower and protects lenders against loss if a borrower defaults. PMI is required by most lenders when you make a down payment of less than 20%.

The premium typically costs 1% of your loan balance per year. And once you’ve committed to paying PMI, you’ll usually have to keep paying it for at least two years. On a $200,000 mortgage, PMI will cost you $2,000 a year on top of your mortgage payment, insurance and taxes. Because a Rent to Own agreement gives you extra time to save for your down payment, you may be able to skip paying PMI altogether.

Leverage

You are spending very little money to control a potentially very expensive and very profitable piece of real estate.

Cautions for rent-to-own buyers

Market price may go down

This is the flip side of the benefit listed above. If the home value depreciates during the lease time, the purchase price you’ve agreed to could be higher than the market value at the time you exercise your option to buy.

If that’s the case, your lender may not approve you for the loan amount you need, because the price you agreed to pay is higher than the appraised value of the home. The risk of this happening may be low. Historically, real estate has appreciated in value in most circumstances and most markets. But it’s certainly possible. It’s important to do your market research and make sure the property you’ve chosen is more likely to appreciate than lose value during the option term.

If the value has dropped significantly, you may be able to simply walk away from the option and lose your option fee and rent credit. Or perhaps the owner may settle for a lower price than previously agreed.

Not qualifying for a mortgage

One of the pros of rent-to-own is that you get time to improve your qualifications for a mortgage while you’re in the home you want to buy. Do your homework ahead of time and know what you need to do to make sure you qualify for the loan amount you need. If the option period expires before you qualify for a mortgage, the seller no longer has an obligation to sell you the rent-to-own listing.

Paying too much above market rents

You want to negotiate a total monthly rental amount that’s not too far above standard rental rates for similar properties.

Let’s say, for example, that you’re negotiating a rent-to-own on a three-bedroom, two-bathroom single-family home in a neighborhood where similar properties are renting for $1,200. The owner may offer to rent the property to you for $1,600 a month, with $400 as your rent credit. This might be an okay setup, especially if you have trouble saving money for the long term.

But if you can negotiate a lower monthly rent credit and be disciplined to save the difference on your own, that would be a better deal. That’s because if you choose not to purchase the home, the seller keeps the option fee and the rent credit you’ve accrued. But the amount you saved on your own is still yours.

Not going through with the home purchase

If you decide you don’t want to go through with the purchase of the home when your lease is up, the seller keeps your option fee and the rent credit you’ve built up. It’s important to remember that you’re renting to own. You need to like the house enough to want to live there for more than the initial lease term.

Not budgeting for home maintenance and repairs

In most rent-to-own cases, the tenant is responsible for maintenance and repairs to the home during the lease period. You need to understand the scope and cost of maintenance and make sure that the home is in good shape before you sign. You might even want to pay for a home inspection so that you know what the issues are — if there are any — before you move in. If there are any structural issues, you’ll want to get the seller/owner to fix them before you enter into a rent-to-own agreement. Everything is negotiable until you sign.

Not working with a reputable rent to own agent

As a buyer in a rent-to-own situation, you want someone on your side representing your interests. There are agents who specialize in rent-to-own. They will educate you on the process, find and show you properties that appeal to your needs and meet your budget, negotiate the best deal and prepare all the legal documents for you. Typically, they charge a one-time fee of $2,500 to $3,500 to handle everything. That’s actually quite a bargain when you consider the service provided and the protection their expertise provides for you.

Beware of scams

Unfortunately, rent-to-own is an option that has been tainted by a few companies with a poor reputation in the housing industry for taking nonrefundable deposits from tenants who clearly won’t ever be able to qualify for a mortgage or afford the home they’re hoping to buy. Buying a house is an emotional experience. You can fall in love with a home and ignore the numbers. You need to advocate for yourself and make sure you can afford home ownership and qualify for financing when your lease runs out.

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Traditional mortgage vs. rent-to-own

How do you find rent-to-own homes?

Lots of properties are on real estate aggregator sites, but it can be a challenge to find properties where the sellers have considered the Rent to Own option. Still, you can check on places like Realtor.com, Trulia and Zillow. Or you can use HomeLight to find a real estate agent in your area who can help you find a Rent to Own property in your area.

In general, real estate agents are not in the business of educating buyers or sellers about their Rent to Own options. They make their commissions on listing and selling properties outright. There are some licensed real estate agents who have specialized in Rent to Own deals. You’ll end up meeting a few of them when you inquire about homes you search for that are listed as Rent to Own. There are some rent-to-own websites, but most charge a membership fee to view detailed information.

The best option may be to ask the seller of a home you’re interested in if they’d consider Rent to Own. When a home has spent a higher than average number of days on the market, a seller might be very interested in moving forward to start collecting rental income to cover their holding costs.

Even better, search the regular rental listings, and when you find one you like, ask the owner if he’d consider rent-to-own.

A rent-to-own arrangement can be a great alternative to purchasing a home through a traditional mortgage for a lot of reasons you might not have considered. Do your due diligence, educate yourself and find a reputable, licensed agent to work with.

Alternatives to a rent-to-own home

Given all the risk on the buyer’s end, rent-to-own may not be the right approach for most aspiring home buyers.

If your biggest challenge is saving up for a down payment, know that there are already government programs designed to make buying a home more affordable for those who struggle with that aspect of achieving homeownership.

When you think about it, why wouldn’t you just put aside the extra money you’d pay to save up for a down payment instead? And with it in your own bank account, you’d get to decide for yourself how to invest it. If your finances need straightening out, the best option for you would be to stay in a rental you can afford and continue to chip away at your debts. When you’re back in the black, then you can put aside the funds you’ll need to buy a home.

You may find, with a little time and focus, that you’re closer to fulfilling your dream than you’d originally thought.

with files from Sigrid Forberg