What should you do if you find yourself in the same position as millions of Americans who want to buy a home, but for whatever reason cannot secure a home loan? Over the last six or seven years, the practice of leasing/renting a home with the option to buy has become increasingly popular. But pcause “rent-to-own” (or “lease-to-own” as it is also called) transactions are occurring more frequently does not mean they are ideal for everyone and all situations.
- How Does Rent-to-Own Work?
- Rent-to-Own: Advantages and Disadvantages
- Who Should Consider a Rent-to-Own?
Is it a good idea?
When the U.S. housing market began to falter in 2007, economists optimistically predicted a recovery within a few years. We are now closing in fast on 2016, and many parts of the country are still experiencing stagnant or declining home values. While Forbes has reported that people like Warren Buffett predict the housing market could rise out of its slump by mid-2017, a recent FICO® survey ominously reports that housing probably won’t rebound until 2020, and that’s being optimistic!
Most of the last decade was considered a “seller’s market”, but with homes languishing on the market for months instead of just weeks or days, many eager sellers are finding that the buyers simply aren’t there. Home sales are so sluggish, in part, because buyers are concerned with general issues of financial stability (i.e., “Will I have a job in a year?”), and because even the most responsible borrowers are having trouble securing Loans. When you add in the fact that many housing markets remain inflated, and that an increasingly large percentage of home sales involve complex transactions (foreclosures and short sales being the tip of the iceberg), it’s no wonder that potential home buyers are content to sit this market out, at least a little longer.
However, purchasing a house is still one of the best investments one can make, and historically low Interest rates mean home ownership is more enticing than ever. But what do you do if you find yourself in the same position as millions of Americans who want to buy a home, but for whatever reason cannot secure a Home Loan? Over the last six or seven years, the concept of leasing/renting a home with the option to buy has become increasingly popular. But just because “rent-to-own” (or “lease-to-own” as it is also called) transactions are occurring more often does not mean they are ideal for everyone and all situations. One would be wise to pay attention the warnings offered by industry analysts and insiders at Realtor.com and Zillow.com, and get educated on all elements of this practice. Simply put, a lot can go wrong. In fact, if you look at all of the risks and rewards associated with the rent-to-own process, it’s easy to see why many potential home buyers should avoid it.
How Does Rent-to-Own Work?
Before determining whether the rent-to-own option is right for you, understanding some important concepts unique to this process will prove invaluable.
Suppose you want to purchase a home. Let’s say you have a stable job and have calculated how much home you can afford, but are having difficulty getting a Mortgage.
Banks may not want to extend financing to you because of a sub-optimal Credit Score, a previous bankruptcy, insufficient money for a down payment, etc., despite the fact that you could afford the monthly mortgage payments. You and/or your realtor find a home that seems perfect and ask the seller to consider allowing you to lease the home, with the goal of purchasing it by the end of a specified period of time. If the seller agrees, you’ll be able to move in to your new home (as a renter) within a few weeks, and be well on your way to home ownership!
Seems like a great idea, but before you decide that a rent-to-own is right for you, here are some general concepts that are important to understand.
- Lease term – The renter agrees to reside in the seller’s home, paying rent to the seller for a specified period of time, after which the renter may purchase the home. Usually, a lease term ranges from 1 to 3 years, depending on how much time the renter needs to secure financing, etc.
- Lease-purchase vs. Lease-option – Although these terms sound similar, failing to understand the difference between the two can mean trouble for both renters and sellers. A lease-purchase is the same as renting-to-own: the renter and seller enter into a legally-binding contract that says the renter agrees to purchase the home by the closing date (which may be set 1 to 3 years down the road). Thus, the home is “held” for the renter until a predetermined date. Comparatively, a lease-option provides the renter the option to purchase the home at lease end, but without the stipulation that the renter has to purchase. This also means that the seller is not obligated to “hold” the home for the renter, and may sell it to a third party at lease end.
- Option fee – All rent-to-own agreements require the renter to pay a non-refundable option fee to the seller. This fee, essentially a deposit, is usually set at 1% to 5% of the home value (the renter can expect to pay at least $5,000 for most homes), and is paid up-front. In the contract, the option fee is usually designated as a Credit towards the renter’s down payment, but only if they purchase the home at lease end. In most cases, if the renter does not purchase the home (even if it is through no fault of their own), they do not get their option fee returned.
- Rent premium – In a rent-to-own contract, the renter agrees to a monthly payment that is affordable. The seller will likely try to ask the market rate (but may request a higher monthly payment depending on how much of their mortgage payment they wish to off-set with your rent). Once the base monthly rent is decided, the renter has to pay an additional rent premium. This rent premium, paid each month in addition to the base rent, goes towards the renter’s down payment in the event that the renter purchases the home at lease end. However, if the renter fails to make a payment on time, many lease contracts stipulate that the rent premium for that month may be forfeited (in other words, the seller gets to pocket that money, even if you purchase the house at lease end). Additionally, if the renter does not purchase the home (for whatever reason), they do not get any part of their rent premium returned.
- Assignment clause – Prior to lease inception, a renter can ask for an assignment clause requesting more flexibility in the lease terms, particularly in the event that they do not end up purchasing the house from the seller. These are advantageous for renters because they often stipulate that all or a portion of the option fee and rent premium be returned to the renter if the purchase falls through. However, it is also difficult to get a seller to agree to such a clause.
- Purchase price – If the renter enters into a lease-purchase agreement, the renter and seller agree what the purchase price will be once the lease ends. Regardless of whether the home goes up or down in value, this purchase price remains the same. However, if the renter enters into a lease-option agreement (which, remember, is different from a lease-purchase agreement), it is possible for the renter and seller to set an initial purchase price that becomes adjustable and/or negotiable at the end of the lease term (e.g., the renter and seller may agree to split the difference in home value at lease end).
Rent-to-Own: Advantages and Disadvantages
It is important to understand the advantages and disadvantages to the a rent-to-own process.
Advantages Associated with Rent-to-Own
The concept of renting-to-own a home has become increasingly popular as potential home buyers find it more difficult to secure financing and/or provide sufficient down payments. A rent-to-own generally allows potential buyers to :
- begin the process of home ownership for the price of renting
- build equity (if they end up purchasing the home)
- lock in the purchase price on a home now, even if it appreciates by lease end
- get into a home that they cannot afford now, but may be able to at some point in the future
- experience the neighborhood and decide if they really want to live there
- understand the real condition of the home and make necessary repairs
- have time to fix Credit Score deficiencies in order to qualify for the best Loan rates possible
- save money for the down payment (in the form of the rent premium and option fee described above)
The rent-to-own option is also advantageous for sellers whose homes remain on the market for too long, and/or who cannot afford the cost of multiple mortgages. A rent-to-own generally allows potential sellers to:
- off-set their Mortgage costs by having a renter
- lock in the purchase price on a home now, even if it depreciates by lease end
- relinquish responsibility for home repairs and costs to the renter
- charge higher than market rent prices (because the renter is motivated by the possibility of owning the home in the future)
- keep the option fee and any/all rent payments (including the rent premium) if the renter defaults in any way and/or does not purchase the home
- secure an automatic buyer at lease end
Disadvantages Associated with Rent-to-Own
A rent-to-own home may be advantageous for both potential buyers and sellers, and is sometimes described as a win-win situation. However, in order for the process to truly be win-win, a certain set of circumstances must be in place. The following scenarios should inform your decision to lease or not to lease; because, to be honest, a lot can go wrong in the time between lease inception and termination.
- Just as the renter cannot get financing now, they could still fail to qualify for financing in the future. Financial markets could change, tightening lending standards more than they are currently. During the lease term, the renter could lose their job, experience a job transfer, go through a divorce, suffer a serious and costly illness, or some other significant change that makes it difficult to get a Home Loan.
- The renter could lose Interest in the home. Perhaps they realize the house is over-priced, the neighbors are annoying, or that significant repairs are needed to make the home livable.
- The renter could fail to save enough money for the needed down payment, thus failing to get financing.
- The home could depreciate in value by lease end, causing the renter to pay significantly more than the home is worth. This could cause the buyer to be underwater on the home from the start.
- The current seller could fail to keep up with the mortgage, causing the home to go into foreclosure.
All of these scenarios result in the renter failing to purchase the home. When the purchase falls through, the renter will probably lose all of their investment in the home, including the option fee (their deposit), the monthly rent premium (the amount paid over the base rent), and any money they may have spent on home repairs. When accumulated, these losses could easily soar into the tens of thousands of dollars.
Who Should Consider a Rent-to-Own?
Leasing-to-own a home is not appropriate for everyone. However, potential renters who meet certain criteria could be ideal candidates for this option.
Renters who cannot get financing now, but who are certain they will be able to secure a sufficient Loan within a year should consider renting-to-own. Renters who need to lease for 12 months or less are also ideal. Keeping a short lease term will lower some of the risk associated with rent-to-own transactions by limiting the number of rent premiums paid, while increasing the likelihood that the agreed-upon purchase price will be close to the actual value of the house at lease end. In correlation, because shorter lease terms mean having fewer rent premium payments, the renter needs to have a significant portion of the down payment already saved. Ideally, renters need to be significantly confident that their life circumstances will remain pretty stable, and that their financial situation will improve over the next 12 months or so. Finally, drawing up a lease-purchase or lease-option agreement is something the renter or seller should do with the help of an Expert; both should consult a reputable real estate agent and/or attorney who will draw up a contract that is fair to both parties and that will minimize loss should something go wrong.
Ultimately, a rent-to-own is not a good option for people who are eligible for conventional financing. There are no accurate statistics on what percentage of people who lease actually go on to purchase the home, with some claiming that it’s as low as 10%, and others claiming 40-50% (at best, half of renters lose their investment). While these estimates are cause for concern, the very absence of quantifiable data here should make anyone skeptical that rent-to-own is the best path to home ownership.
Realistically, there are simply too many variables outside of both the renter’s and seller’s control to make leasing a wise decision for most people. Instead, many people are better off being conventional renters, saving for a down payment on their own, taking time to fix their Credit, and being honest with themselves about how much home they can truly afford.