In this post, we will discuss how rent to own works, the common questions, and concerns around Rent-To-Own Programs:
What is Rent-to-Own
Who can benefit from the Rent-to-Own program?
Benefits of Rent-to-Own
How does Rent-to-own work? Steps for enrolling with Rent-to-Own program.
Rent-to-Own programs watch-outs
What is Rent-to-Own
If you’re like most homebuyers, you’ll need a mortgage to finance the purchase of a new house. To qualify, you must have a good credit score and cash for a down payment. Without these, the traditional route to homeownership may not be an option.
A rent-to-own is an alternative if you cannot get a mortgage today. With rent-to-own, you rent a home for a certain amount of time, with the option to buy it before the lease expires. A rent-to-own arrangement is one in which you pay rent every month to the owner/landlord, just like you would as a tenant. However, with a rent-to-own program, a portion of the rent you pay goes towards your down payment for the future purchase. This amount is called rent credits. A rent-to-own program gives you the opportunity to grow your down payment while living in the home as if it was your own.
According to the contract with the investment of a rent-to-own company (we will refer to both as Investor through the article) they must sell you the home you are renting at the end of the lease. In some cases, you can add an option to buy your home sooner than the lease-end.
Before forming a contract with you, the investor will analyze your credit report, financial situation to understand what lease payment you can afford every month as well as whether you will be able to obtain a mortgage for the property at the end of the lease. The investor usually does not pay as much attention to your credit score as soon as it can be repaired over the course of the lease term. The most important factor for the investor is the amount of your income and its stability. The last factor is your downpayment. The investor will want a downpayment (which is called option credit, option deposit, or option consideration) from you before the lease starts to make sure you are serious about buying this house at the end of the lease period. The option consideration may range from 2 to 3% of the purchasing price of the house and may go up to as high as 5% or more if the investor thinks your case is riskier than they usually have (e.g. lack of stable income, lack of confidence in your determination to repair your credit score). This option consideration will be returned to you at the end of the lease period and will go towards the downpayment for the mortgage you will be taking at that moment.
Who can benefit from the Rent-To-Own Program?
Self-Employed People. Self-employed people often struggle to prove their income. Also, many banks want to see a stable income. As a self-employed person, you also may have a lower credit score. With the rent-to-own program, you can own a home, build sufficient down-payment, as well as prove stable income to the bank when the lease ends.
Bankrupt. Bankruptcy put a hole in your credit report. Once the bankruptcy is discharged it takes 2 to 3 years to repair the credit score to a point when big banks will want to give you a mortgage at good interest rates.
New to the Country. Getting a mortgage can be tough as an immigrant due to a lack of credit history and, as a result, low credit score.
Divorced. Divorce can often negatively affect your credit score.
Recovering from past credit mistakes. Everyone deserves a second chance and past credit mistakes (if you are serious about fixing them) should not prevent you from owning your home. You can read more about improving your credit score here: How to improve credit score? How is credit score calculated?
Benefits of Rent-to-Own
As discussed above rent-to-own can benefit those recovering from bad credit scores or people who cannot prove a good credit score/income (self-employed people). Thus, there are 3 main benefits to the rent-to-own program:
1. Owning a home of your dream today.
There are 2 types of rent-to-own programs. Under the first, you get a choice from pre-selected properties that you would like to rent and then own. With the second type, the investor will allow you to pick any property in the market that you like as soon as it is within your budget. In both types, the investor buys the property you chose and leases it to you for a pre-agreed lease term. At the end of the lease, you buy the home from the investor. In any case, you live in the property of your dream from day one.
2. Building down-payment for your future mortgage.
As discussed previously, part of your monthly lease payments will go towards your future mortgage downpayment (rent credits or rent consideration). In addition, the initial downpayment (option consideration) that you give to the investor at the beginning is also returned to you at the moment of lease-end and you purchasing the home from the investor. This money also goes towards your mortgage downpayment.
Let's look at an example of rent-to-own payments and how much you can expect to receive for your mortgage downpayment at the end of the lease.
In our example, you decide to enter a 3-year agreement with the investor to lease-to-own a home with the current purchase price of $400,000. The investor asks you for a downpayment (option consideration of 5%). The investor asks for a monthly payment of $3,000, $800 of which will go towards your future mortgage downpayment (rent credits).
Thus, at the end of the lease term, you should expect to have the below downpayment for your mortgage:
$20,000 option consideration (5% of 400,000 purchase price)
$28,800 rent credits ($800 times 36 months)
3. Repairing your credit score along the way.
A good investor is always interested in you buying the property from them at the end of the lease term both for financial and reputational considerations. The investor realizes a financial gain from the sale. Also, investors want to make sure that they have a good reputation for the long run and build their future client base based on recommendations from past clients. Thus, they need to make sure you get approved for a mortgage at the end of the lease term. To help with this, investors often partner with a credit repair specialist who will look at your credit score, analyze your spending and debt habits, and income to understand if you will have a sufficient credit score to obtain a mortgage at the end of the lease term. Also, investors work with mortgage brokers to understand if you will be able to afford a mortgage at the end of the lease. Before banks give a mortgage they look at your income and debts to see if you can manage a mortgage, so it is good to know if you will be approved for a mortgage at the end of the lease (usually 3 years) before you even get into this lease agreement with the investor.
How does Rent-to-own work? Steps for enrolling with Rent-to-Own program.
Step 1. Find an investor/rent-to-own company. This step is important as you will want to check their references and reviews.
Step 2. Fill the initial application, have a meeting with the investor to review your financial situation, credit report, and agree on the maximum purchase price for the home you can afford. Get approved.
Step 3. If you don't have a house in mind, you start looking for a house, working with your preferred realtor or a realtor provided by the investor to find a home within the budget set in the agreement with the investor.
Step 4. Once a house is found, the investor and the realtor work to negotiate and finalize the sale agreement. A Home Inspection is usually done at this stage to ensure that the house is free of major issues and that you can afford to pay for any necessary repairs or improvements that may be needed
Step 5. you and the investor sign one of two types of agreements.
There are two types of legal agreements to choose from with rent-to-own homes.
The first, a lease agreement with an option to purchase. This contract gives you the right but not the obligation to buy the home at the end of your lease. If you decide not to go through with the purchase, the option expires, and you can walk away. But you will lose the money that you paid over and above the rent. This is the most common type of agreement among the investors.
The second, lease agreement with a purchase agreement. With this type of agreement, you could be legally obligated to buy the home at the end of the lease. With this type of contract, you’ll want to be extra sure to have a home inspection done to make sure there are no surprise expenses once you become the owner. You may also want to get pre-approved for a mortgage to be sure you’ll qualify for one when you need to.
Step 6. The investor buys the house in the market you picked. At this moment, until the end of the lease term, the investor owns the house and leases it to you.
Step 7. You move in and your lease starts. Along the way, you will be paying monthly lease payments which consist of 2 portions:
The rent portion – money that goes toward the mortgage, property taxes, and insurance.
The savings portion – money that goes toward your down payment. By the end of the lease term, you’ve saved the necessary amount to make up your full down payment required
Step 8. During your lease term, the investor works with you to improve your credit score through our credit repair program and offering coaching on budgeting and improve your money mindset.
You also are able to do improvements to the home during this time to maximize the value of your home. In this win/win situation, your home will be worth more than the predetermined purchase price.
Step 8. When the rent-to-own term is over. The investor sells you the house at a price predetermined in the lease and purchase agreement that you form at the beginning of the lease. At this moment, you should have repaired your credit score and have enough of a downpayment to obtain a normal mortgage through one of the banks to buy the property.
Rent-to-Own programs watch-outs and need-to-knows
As with any other business, there are good and bad investors/rent-to-own companies. Usually, the investor has a long-term investment mindset and will want to keep their good reputation for the future. However, there are cases of dishonest investors who may want to take advantage of you. To protect yourself, make sure to do due diligence check for references, search the investor online. Also, given you will have to sign a contract you should consult with a layer. Make sure you read carefully the contracts and know what you are paying, for what you are paying, and make sure to ask any questions you may have. Pay close attention when meeting with a mortgage broker and credit repair specialist to understand the steps to be approved for a mortgage at the end of the lease term.
You have to understand that if you are unable to buy the property at the end of the lease term or walk away from the lease in the middle of it you will lose all the money you put down: the downpayment money you put upfront (option consideration) and the money you were putting every month towards your future mortgage downpayment (rent credits).
Pay attention to amounts that you pay for the lease vs. how much you will be saving (rent credits). Usually, the saving portion is around 25 to 30% of the monthly payment. You would want to obviously save more and pay less in lease.
The price at which you will be buying the property from the investor at the end of the lease term is predefined in the lease and purchase contract. The contract will include an annual appreciation of the price of the house, meaning the price you will be buying is higher than the price at the moment you enter into the rent-to-own contract. The rate of appreciation will depend on the market and the overall appreciation of the prices in the market. Usually, you should expect a 3 to 8% annual appreciation built-in. Thus, if you have selected a house that is worth $400,000 today, and the annual appreciation is set in the contract at 5%, at the end of the lease term you will be buying the house for $400,000*1.05*1.05*1.05 = $463,050
Define who pays for what during the lease term. When your landlord owns the house, but you plan to buy the house, you both have reasons to want to keep the property in good shape—or you both may feel the other person should be obligated to do it. Because rent-to-own homes are unique situations, maintenance and repair obligations should be clearly laid out in your lease agreement. Usually, the investor, as property owner during the lease term, pays property tax. However, insurance, maintenance, repair costs are usually pushed down to you.
You are hooked for 3 years to pay monthly lease payments and have to follow the guidelines for improving your credit score. Most of the time, it is not a problem, but you would need to take caution about unforeseen events. Also, during the lease term, you should expect regular check-ins with credit repair specialists and the investor to check your progress in repairing your credit score. Lastly, you need to cut your spending and watch your debt. The last thing you want to happen is extra debt for a new car you bought reducing your monthly disposable income preventing you from obtaining a mortgage. You should consult with the investor, credit repair specialist, or mortgage broker to check the potential impact of the new debt on your credit score and ability to obtain a mortgage. You can read more about mortgage brokers here: What is a mortgage broker? What do mortgage brokers do?
WHY DO I HAVE TO SEND MONEY UPFRONT?
The initial payment demonstrates you are serious and want to move forward. Also, it protects the investor from you suddenly changing your mind as they will keep the downpayment (option consideration).
WHAT HAPPENS IF I CAN’T PURCHASE THE HOUSE AT THE END OF THE RENTAL TERM?
This is a common concern, especially in a weak economy. However, if you think about it, the risks are not much different from owning a mortgage. If you suddenly cannot pay the mortgage, it would take a little time until the bank forces you to sell the property.
Usually, if you stick to the credit repair plan, you should have no problem qualifying at the end of the rental term. If the reason is due to job loss or any other unforeseen events in the family, the situation would need to be discussed further with the investor. Usually, as long as you genuinely are making strides in repairing their credit or saving their down payment, there are things that can be done, such as a rental term extension. You can also obtain insurance against common risks for the length of the lease-to-own term.
HOW MUCH OF A DEPOSIT DO I NEED TO PUT DOWN?
The deposit required is between 2 and 5% of the purchase price of the home. The larger deposit you can put down, the better it will be for you because the deposit is credited toward the purchase price at the end of the rental term. Also, the bigger the deposit, the more negotiation power you have when discussing your monthly lease payments.
WHO IS IN CHARGE OF MAINTENANCE?
Usually, it is the tenant (you) who is responsible for all maintenance and repairs to the property, including any initial issues that may be discovered during the home inspection.
WHO PAYS FOR THE HOME INSPECTION?
Usually, it is the tenant (you) who is responsible for the cost of the home inspection. Since the house will be yours, it is best to know ahead of time any issues with the house and the actions you will need to take, both immediately and in the future, to ensure the house continues to be in a state of good repair.
WHO PAYS FOR THE PROPERTY TAXES?
During the rental term, the investor usually pays the property taxes. After you exercise the option to buy the property, you will then be responsible for the taxes.
WHAT ABOUT INSURANCE?
It is usually the investor who will be responsible for property insurance during the rental term, after which you will take your own property insurance.
WHO PAYS FOR UTILITIES?
The tenant is responsible for the utilities including water, heat, gas, hydro, and any other utilities payments that may apply, depending on the province they will be living in.