What is a Rent-to-Own Home, and is it Worth It?

Home Buying

Jan 21

Rent to own homes worth it financial planning investment management CFP independent RIA retirement planning Ridgewood Bergen County NJ.

Home prices have soared over the last several years. According to Zillow, the average U.S. home price was just over $240,000 back in mid-2019. Today, this number rings in at $356,585: almost a 50% increase!

While significantly higher home values may comfort existing homeowners, renters seeking to buy a home are left frustrated—mainly because it’s much more challenging to save up for a significant down payment and get approved for a mortgage. Consequently, many prospective home buyers explore less traditional routes to homeownership, including rent-to-own home programs.

What is a rent-to-own home?

A rent-to-own program is similar to leasing a car, giving someone the chance to “test drive” a home for a specific period of time (generally one to three years) with the option to buy before the lease expires.

A key difference, however, is that those who enter into rent-to-own agreements do so with the intention of purchasing the property—since, depending on the contract, a portion of the monthly rent payment goes toward the down payment or an upfront, non-refundable “option fee” is required to lock in the option of buying the home.

How rent-to-own homes work

Rent-to-own-home details vary depending on the contract.

In a lease-purchase agreement, for example, you lease a home for a few years and a percentage of your monthly rent is set aside, typically held in escrow, and used towards the down payment. Entering into this means you’re obligated to buy the home at the price at which you “locked in” at the start of the contract.

Should you choose to buy as part of a lease-option agreement, meanwhile, you’ll pay the owner an option fee (typically 2–7% of the home’s value) when you sign. This fee is also often held in escrow and (in most cases) reduces the overall purchase price. In this case, you’ll negotiate a purchase price with the seller after your lease expires and will have the option to walk away without buying the home (but will likely lose your option fee in doing so).

Regardless of the option you choose, you’ll still need to qualify for a mortgage should you decide to buy the home at the end of your lease. Those who don’t qualify might face legal consequences in addition to money likely lost, depending on exact contract details.

Rent-to-own-home advantages

· They help save for a down payment. Anyone struggling to save for a down payment will appreciate how a rent-to-own home can direct a portion of rent payments toward the purchase price.

· They can strengthen your finances. If you can’t afford to buy a home because you’re bogged down by too much debt or have shaky credit, your rental period is useful for repairing your credit and/or paying off any debts—with an improved credit score and less debt boosting your chance of a mortgage approval and receiving a good rate.

· They help avoid competition. At the end of the rent-to-own agreement, buyers can avoid competition from other buyers because these contracts often give renters exclusive rights to purchase the home.

· They can be a profitable investment. Rent-to-own lease-purchase agreements allow you to lock in a purchase price early on, a profitable feature if you find yourself in a hot real estate market with escalating home prices at the end of your lease.

· They won’t “waste” all your money on rent. Making monthly rent payments is a little easier to digest when you know some of that money is going towards a down payment on the home.

· They help you experience a home before buying. The rental period is very appealing as it gives you time to familiarize yourself with the neighborhood and surrounding areas; and if you ultimately decide to walk away at the end of your contract, you can (depending on the contact).

· They prevent an additional move. Moving is not only a hassle but also often costly.

Rent-to-own-home disadvantages

· Rent is more expensive than in a traditional lease. If part of your rent payment is going towards building equity in the home (as in lease-purchase agreements), experts suggest it’s perhaps more beneficial to save that money on your own—especially true when considering all the risks involved with rent-to-own contracts.

· You may end up paying more than the home is worth. It's impossible to predict what the real estate market will look like at the end of a lease, meaning locked-in prices may not be as attractive as they once seemed—especially if you end up in a down market with significantly depreciated home values.

· You can lose a lot of money if you decide not to buy. Perhaps you find yourself unable to qualify for a mortgage or need to relocate for work. Regardless of the reason for not buying, you will probably forfeit the money you paid to your landlord (including any extra payments meant to go towards the purchase price of the home).

· You may be on the hook for property maintenance and repairs. Depending on how your contract is structured, you may be required to maintain the property and pay for repairs that would otherwise be the responsibility of a landlord. If this is the case and you fail to do so in a timely manner, you may forfeit your right to buy the property as sellers often include a clause in the contract stipulating this. It’s therefore important to ensure maintenance and repair requirements are clearly outlined in your agreement.

· The deed isn’t under the renter’s name. Consequently, the renter has no real authority over property affairs (and in the event of a foreclosure, the home goes to the bank instead unless this specific scenario is addressed in the contract).

How to find rent-to-own homes near you

Multiple ways to seek out rent-to-own homes include working with a real estate agent or visiting dedicated websites such as renttoownlabs.com, divvyhomes.com, thinktrio.com, verbhouse.com, and homepartnersofamerica.com (note we aren’t affiliated with any of these sites).

Be wary of rent-to-own-home scams

It’s important to know that rent-to-own scams are prevalent. For example, a scammer may find a vacant home for sale or rent and advertise it online with contact details to steal your identity (via an application) and/or procure a deposit from you.

It’s also not uncommon for renters to learn after the fact that the owner is behind on property taxes or the home has mold, lead, or asbestos issues: speaking to the importance of properly researching the home, obtaining an inspection, and ensuring there are no liens on the property. You should also research the seller by checking his/her credit report and obtaining a title report to learn how long he/she has owned the property.

A real estate attorney can review your contract to help ensure you’re getting a fair deal.

Rent-to-own-home alternatives

You do have options outside of rent-to-own programs—including FHA and VA loans, down payment assistance programs, and low-money-down conventional mortgages—to help save for a down payment on your own.

An FHA loan is a government-backed mortgage insured by the Federal Housing Administration that helps consumers—often first-time homebuyers—who have lower credit scores and lack the cash necessary to afford a 20% down payment. These are available in 15- and 30-year term options with fixed rates, and you can apply via FHA-approved lenders (assuming you qualify).

If you currently serve (or have served) in the military or are a surviving spouse of someone who died while on active duty (and have not remarried), you may qualify for a VA loan: a government loan requiring no down payment.

Down payment assistance programs—designed to help households who can afford mortgage payments but lack enough money for a down payment and closing costs—are typically run by state/local governments and nonprofit community groups and provide homebuyers with loans or grants. Research your state’s HFA (House Finance Agency) and browse the U.S. Department of Housing and Urban Development (HUD) website to get started.

Finally, you should also look into lenders that offer conventional mortgages (any mortgage not offered or insured by the government) but with smaller down payment options. You can obtain these at banks, credit unions, and other financial institutions but may have to do some digging to identify the minimum down payment required. Also know that if you put down less than 20%, you’ll be required to carry private mortgage insurance (PMI) until you meet certain conditions (e.g., when your loan-to-value ratio reaches 80%).

The bottom line on rent-to-own homes

Rent-to-own homes may make sense for some, especially first-time homebuyers who aren’t quite ready to obtain a mortgage and need more time to build up a good credit history. Though these properties are sometimes profitable in a rising housing market with a locked-in purchase price, we generally believe rent-to-own agreements come with far too many risks that outweigh any potential benefits and thus recommend avoiding these if possible.

Have questions while trying to decide if a rent-to-own home is right for you? Schedule a FREE discovery call with one of our CFP® professionals so we can help!