Rent-to-own can be a great arrangement for landlords and tenants alike. It is great for landlords who want an exit strategy from the rental property and don’t want to be a landlord forever.
Rent-to-own can be equally great for tenants who want to become homeowners but aren’t quite yet there from a mortgage qualification standpoint.
Of course, rent-to-own isn’t right for everyone though and it isn’t without its risks. Read on to understand everything involved
- What is a rent-to-own?
- How does rent-to-own work?
- What portion of the rent goes towards the rent credit?
- How was the home’s final selling price determined?
- Who benefits from rent-to-own arrangements?
- How do you get a mortgage for a rent-to-own property?
- The rent-to-own agreement
- Is it worthwhile?
- What are some of the pros and cons of rent-to-own?
- How to purchase a rent-to-own home
- What to look for in a rent-to-own agreement?
What is a rent-to-own?
Rent-to-own is an agreement entered into by a landlord or rent to own company, and a tenant and aspiring homeowner. As a tenant, rent-to-own is similar to the regular rental agreement, except with a major difference.
Instead of the money just going towards paying the landlord’s mortgage, a portion of the rent is earmarked for the down payment that the tenant will eventually be making. This is called the rent credit.
Rent credits are the down payment building feature of renting-to-own.
A rent-to-own agreement can be as short or long as the landlord and tenant agree to. Most rent-to-own agreements tend to be one to five years long.
Rent-to-own agreements usually offer flexibility. The tenant can typically purchase the rent-to-own home once the lease expires or sometimes while the lease is still in effect.
The tenant doesn’t have to go through with the purchase. This has a cost.
If the tenant decides not to buy the rent-to-own property, the tenant can lose all of the rent credits. As a tenant, you want to get all the details before making a major decision like this, as you could be out hundreds or thousands of dollars.
Housing prices and rent to own
The tenant and landlord agree at the start to the selling price of the home. If home prices drop, the tenant may regret buying the home at a higher price than market value.
Rent-to-own doesn’t just carry risks for tenants. It has risks for landlords as well.
If the house prices go up, the landlord may regret selling the home to the tenant, as he could sell it for a lot more on the open market. But he can’t just cancel the rent-to-own agreement.
At least not without the tenant’s mutual agreement. The landlord must sell the property to the tenant in unless the tenant also wants to cancel it.
How does rent-to-own work?
A rent-to-own agreement is made up of two parts. There’s the standard rental agreement and the rent-to-own agreement.
Two types of rent-to-own agreements
When it comes to rent-to-own agreements, not all of them are the same. They tend to come in two different kinds: the option to purchase and the lease purchase.
Option to purchase
Under the option to purchase, the tenant has the option of buying the home being rented at some point in the future. However, it’s just that; an option.
The tenant doesn’t have to buy the property if he doesn’t want to. This gives the tenant the utmost in flexibility.
There are many reasons a tenant might decide not to move forward. The tenant may want to move to another city or province, or the home may no longer suit him. Whatever the reason, the tenant can get out of the agreement without paying a penalty because it’s just an option.
Lease to purchase
The second type, the lease purchase, is slightly different. With the lease purchase, the tenant agrees to purchase the home he’s renting either in the middle of the lease or by the time the lease ends.
If the tenant follows through, then everything is good. However, if the tenant doesn’t follow through, as mentioned it could mean losing the rent credit. It could also mean other penalties the tenant owes.
With that in mind, it’s best for a tenant to only sign this type of agreement if he’s certain he’ll want to and be able to purchase the home by the end of the lease agreement.
What portion of the rent goes towards the rent credit?
The formula isn’t standard. Sometimes only 5% or your rent goes towards the rent credit. Sometimes it might be 25% or 30%. You want to know all of this ahead of time.
The higher the percentage that’s going towards the rent credit, the more risk for the tenant. That’s because the tenant has a lot more to lose if he doesn’t move forward with the rent-to-own agreement before it expires. He has a lot more money to lose in rent credits if he doesn’t.
How was the home’s final selling price determined?
Buying rent-to-own is a lot like pre-construction. Similar to pre-construction, the landlord assumes some sort of price appreciation over the time that the tenant owns the property. As the tenant, you’ll want to know what this price appreciation assumption is.
For example, if it’s only 2% or 3%, that’s pretty reasonable. However, if the landlord is assuming price appreciation of 6% or 7%, that’s when it’s a lot less reasonable, and the tenant has a lot more to lose.
If the actual price appreciation doesn’t happen, that means that the tenant is overpaying for the home. Not only that, but the tenant may also not be able to get mortgage financing if the appraisal comes in short.
Who benefits from rent-to-own arrangements?
As a tenant, a rent-to-own agreement only makes sense if your intention is to become a homeowner and you want to buy the place that you’re renting.
If you’re unsure homeownership is right for you, or you’re not completely sold on the place that you’re renting as a long-term home, it’s likely best for you to pass on the opportunity.
For tenants, rent-to-own is worth considering when you would like to be able to buy a home as soon as you’re able to, but you need some more time to save money.
Good people and poor credit scores
Rent-to-own makes the most sense for tenants who are good with their money but cannot qualify for a traditional mortgage. If you have a low credit score, rent-to-own helps you mitigate it. You can get a mortgage from a subprime lender, or you can do rent-to-own.
For example, a tenant might be newly self-employed. With traditional lenders, he might need to show two years of tax returns. That’s when rent-to-own can make sense. He could do rent-to-own until he has the two years and then move forward with buying the property.
Another issue is someone who was recently discharged from or is only a few months from being discharged from a consumer proposal or bankruptcy. Traditional lenders typically want to see two years of being discharged and a rebuilding of your credit score before they will approve your mortgage application.
These are just a couple examples of the way rent-to-own can help a tenant become a homeowner sooner.
Why is rent-to-own good for landlords?
It can be great for a landlord who is looking to get out of the business of renting properties in the next few years. You negotiate the sale years in advance, which takes the pressure off of you.
Your tenant is likely to take better care of the property if it might one day belong to them. Plus, your tenant might stay longer than previous renters because they plan to purchase the property.
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How do you get a mortgage for a rent-to-own property?
This is more for the tenant than the landlord. By the end of the rent-to-own agreement, the tenant needs want to qualify for a mortgage. If he can’t, that’s when problems arise.
For the tenant to set himself up for success, it’s important to make sure that the rent-to-own agreement is done right.
The rent-to-own agreement
First and foremost, it’s important that there’s formal rent-to-own agreement signed by both the landlord and tenant. Unfortunately, signing a rent-to-own agreement on the back of a napkin won’t work. The landlord and tenant will have to draft up a proper rent-to-own agreement.
Before taking the time to draft, it’s a good idea to have a mortgage broker and lender review it. The reason for this is that it’s important that the rent-to-own agreement is written the right way.
Mortgage issuers and private lenders are very particular in what they are looking for in a rent-to-own agreement. If it is missing something, that’s when a lender may not be willing to approve a mortgage for it.
It’s a lot easier to get everything done right the first time, rather than having to go back to the landlord and having changes signed after the fact. The landlord may not agree to the changes, which can result in the tenant having limited mortgage options or not being able to get a mortgage at all.
With rent-to-own, both parties should draft up an agreement with the help of real estate lawyers. Each party should have its own real restate lawyer to help draft up and review the rent-to-own agreement. That way important details are a lot less likely to be overlooked and the agreement can be done right the first time.
Mortgage brokers can help with your budget
It’s a good idea to sit down with a mortgage broker and see where you, the tenant, stands from a mortgage financing perspective. See what you need to work on to qualify for a mortgage.
If you’re short on down payment, you can work on saving more money. If you need to improve your credit score, you can do the steps needed to do that. At least you’ll have an action plan and know what needs to be done to qualify by the end of the rent-to-own agreement.
It’s also important to budget for closing costs as a tenant. Some of the closing costs include the appraisal, land transfer tax and real estate lawyer fees. The tenant will need this saved on top of the rent credit in order to close on the property and graduate from tenant to homeowner
Is it worthwhile?
Rent-to-own is good under certain circumstances. Rent-to-own can make sense for tenants who want to buy a home, but don’t want all their money going towards the landlord’s mortgage in the meantime.
A tenant may not be able to purchase a home at this moment because something is temporarily stopping him. Maybe it’s because of a lack of savings. Maybe it’s because the tenant needs some time to improve his credit score. There are many different reasons.
If the tenant has trouble saving money for the down payment, a rent-to-own agreement might be a good option. The rent credits force the tenant to save money.
There’s also nothing stopping the tenant from saving additional money outside the rent credits. The tenant could set up an automatic savings plan, where money comes off his paycheque and is automatically put into his savings account.
It might not be perfect for you
The arrangement isn’t perfect. Until the tenant buys the property, the landlord is still the homeowner. That means it’s like the standard landlord-tenant relationship.
The tenant is required to follow all of the landlord’s rules while living in the home. If the rules aren’t followed, in a worst-case scenario the tenant could forfeit the right to buy the home and lose the rent credits in the process.
What are some of the pros and cons of rent-to-own?
Here are the main advantages and disadvantages of the arrangement.
- As a tenant, you’re able to buy a home at today’s home prices. This can be beneficial if home prices increase faster than you can save.
- There is an incentive for both the landlord and tenant to take good care of the property.
- Similar to a mortgage, rent-to-own is forced savings for the tenant. When the tenant pays the rent on time, rent credits build up and can be used to buy the home.
- If your cash flow situation is already tight, you may not be able to afford the higher payments that come with rent-to-own homes.
- If the tenant breaks any of the rules or isn’t able to move forward with the rent-to-own agreement, the rent credit could be forfeited. That means that the landlord keeps the money put aside for the down payment.
How to purchase a rent-to-own home
Once a tenant decides that rent-to-own makes sense, it’s time to find a rent-to-own property. There are a couple ways to do that. The tenant could approach his existing landlord or he could move to a new property that specifically offers rent-to-own.
Ask your current landlord
Your landlord may not be familiar with the rent-to-own agreement. You have to explain what rent-to-own is and the benefits of it. If the landlord is considering selling the home, rent-to-own can be a great exit strategy.
Listed rent-to-own properties
If the tenant decides to look for a new property specifically for rent-to-own, the process is slightly different. The landlord is already familiar with rent-to-own.
When searching for rent-to-own properties, you’ll want to look for properties advertised this way with the term “rent-to-own”.
If a tenant is having difficulty finding a rent-to-own home, they can approach landlords looking to rent out their properties and see if they’d be willing to do it as a rent-to-own. Again, it might involve some education, since the landlord may not be familiar with rent-to-own and the potential upsides.
As a tenant, offering to purchase the landlord’s home under rent-to-own can be tough. As mentioned, it really only works for a landlord who wants to exit out of the rental market in the coming years.
It also tends to work in a buyer’s market, when the homeowner may have trouble selling his house. In those markets, having a guaranteed home sale can be nice. If it’s a balanced market or seller’s market, that’s when rent-to-own may not work so well.
There’s also the option of working with a rent-to-own company. With a rent-to-own company, you can usually buy whatever home you want.
This offers the tenant the most in flexibility. The tenant should however be extra cautious before signing up under this arrangement. The tenant will want to do his due diligence to makes sure that the rent-to-own company is trustworthy and not a scam.
What to look for in a rent-to-own agreement?
The lease option usually makes the most sense for tenants. That’s because life can change a lot in a few years. What might have made sense for you when you first signed the agreement, may no longer make sense for you a couple years later.
With the lease options, you have the choice to walk away if rent-to-own no longer makes sense to you. Most importantly, you don’t lose your rent credit if you choose not to move forward. You can use the rent credit towards something else, such as the down payment for your own home.
Just be aware that since the lease agreement is beneficial for the tenant, tenants may need to pay a premium for it. Nevertheless, it’s worthwhile in many cases. Having the freedom is a lot better than being locked down for most.
If you’re almost 100% sure you’re going to buy the home, you can sign a lease purchase agreement. Just make sure that you know what you are getting yourself into, as it can prove costly later on if you can’t move forward.
The formula isn’t standard. It can be as little as 5% or as much as 30% of your rent that goes towards the rent credit. You want to know all of this ahead of time.
Similar to pre-construction, the landlord assumes some sort of price appreciation over the time that the tenant owns the property. As the tenant, you’ll want to know what this price appreciation assumption is. For example, if it’s only 2% or 3%, that’s pretty reasonable. However, if the landlord is assuming price appreciation of 6% or 7%, that’s when it’s a lot less reasonable, and the tenant has a lot more to lose.
It’s almost always the landlord, but not always. As a tenant, you want to read all the details of the rent-to-own agreement to make sure you know what you’re getting yourself into. You wouldn’t want to discover that you’re responsible for footing the bill for expenses you didn’t think you were. This could impact how much money you have to put down on the property later on.
It’s important that there’s formal rent-to-own agreement signed by both the landlord and tenant. Before taking the time to draft, it’s a good idea to have a mortgage broker and lender review it. The reason for this is that it’s important that the rent-to-own agreement is written the right way. Lenders are very particular in what they are looking for in a rent-to-own agreement. If it is missing something, that’s when a lender may not be willing to approve a mortgage for it.