Owning a home is many a renters’ dream. It’s a goal that takes years of scrimping and saving to squirrel away a down payment — not to mention the careful spending and meticulous bill-paying required to keep your credit score high.
In the meantime, you’re still paying rent, maybe even more each month than you’d pay for a mortgage payment. But what if a portion of your rent were going toward purchasing your rental home at a later date?
That’s exactly the dream that rent-to-own deals are selling, but what’s the catch with rent-to-own homes?
Rent-to-own basics: Crediting rent toward a future purchase
Also known as a lease purchase or lease option agreement, a rent-to-own contract is an agreement between the tenant and the homeowner that a portion of the monthly rent is credited toward the future purchase of the property.
Then, when the lease ends — typically within 1 to 5 years — you’ve saved up a credit with the homeowner that reduces the agreed-upon purchase price.
Sounds ideal, right?
A rent-to-own deal means you can start paying toward a home purchase even if you can’t technically qualify for a mortgage yet.
“Most people considering a rent-to-own purchase either don’t have a high enough income or good enough credit to buy a house right now,” says experienced Washington state agent Hao Dang, who’s sold over 76% more properties in the Seattle area than the average agent.
2 scenarios when rent-to-own makes sense
Rent-to-own deals are a bad deal for the tenant in many cases, but there are two scenarios when it might just be the dream deal you’re looking for:
1) When it’s part of a government-run community revitalization program
Rent-to-own contracts almost always come with a significant risk factor — unless they’re part of a government-run program.
For instance, community organizers in Milwaukee, Wisconsin worked with financial institutions to convert bank-owned, foreclosed properties into affordable, rent-to-own housing for low-income families.
The only catch in entering into a rent-to-own agreement with the government is qualifying for the program in the first place.
2) When it’s actually a lease-option instead of a lease-purchase arrangement
Lease-purchase and lease-option may sound similar, but there’s one very big difference: one is a requirement and the other is a choice.
- a lease-purchase legally binds you to purchasing the home once the lease is up
- a lease-option gives you the opportunity to buy the house before the lease is up
Yes, lease-purchase and lease-option contracts are types of rent-to-own agreements, but the issues listed below only apply to lease-purchase rent-to-own deals.
7 scenarios when rent-to-own contracts come with a big catch
Rent-to-own contracts (of the lease-purchase variety) sound good on paper, but you shouldn’t sign one without carefully considering the drawbacks, too. Here’s a rundown of the top seven potential problems you need to consider before signing a rent-to-own lease-purchase agreement.
1. You’ll pay more in rent every month than you would as a renter
Let’s face it — landlords aren’t going to credit a portion of your monthly rent toward the purchase of the house out of the goodness of their hearts. They’ll expect something in return.
This “catch” is usually more per month in rent than you’d pay in a simple rental arrangement. And not all of that “extra” you’re paying each month is going toward your purchase credit.
For example, let’s say the standard rent for a property is $1,700 a month, but the landlord is offering a rent-to-own deal for $2,000 a month. Don’t expect to be credited for the whole $300 extra you’re paying each month.
In the fine print of this deal, it could turn out that you’ll be credited just $200 of that $300 each month. So, in reality, you’re paying this landlord $100 simply to “save” money for you.
Plus, that extra that the landlord is “saving” for you every month might not be doing anything to help you purchase the house down the road, like building a nest egg to use as a down payment.
“Rent-to-own doesn’t eliminate the down payment. The portion of your rent is just going toward the price of the house. You’ll still need a down payment when it comes time to get a mortgage,” explains Dang.
2. You’re paying less toward the price of the house than you’d think
Putting several hundred dollars a month toward the purchase of a house before you can actually afford a mortgage sounds like a smart financial move on the surface.
But when you run the numbers, you’ll see that the sum total of the credit doesn’t actually amount to much, even in the long run.
“It’s just like leasing a car. If you actually pay off and purchase a leased car, you’ve paid a lot more than if you’d simply purchased the car outright,” explains Dang.
Let’s say you’re paying $2,000 a month in a rent-to-own deal on a $400,000 home — and the landlord agrees to put $200 a month (or 10% of your rent) toward the price of the house.
That’s only $2,400 in one year.
In five years (the maximum of most lease-purchase agreements), that’s a total of only $12,000 that’ll be credited against the agreed-on purchase price.
And you could pay that much just to get into the deal in the first place, because…
3. Most rent-to-own contracts require a nonrefundable upfront fee
Sure, renters expect to pay fees to lease an apartment or house for things like security deposits and application fees — sometimes as much as two-months’ rent.
But if you’re opting for a rent-to-own deal, expect to feel a little sticker shock.
Most lease-purchase agreements require an upfront, nonrefundable, one-time fee that’s calculated by the home valuation. While the amount is negotiable, it’s typically between 2.5% to 7% of the agreed-upon purchase price.
Do the math, and you’ll see that you’re paying anywhere from $10,000 to $28,000 (on a $400,000 house) just to get into the rent-to-own deal.
That may be around the same or double what you’ll pay again in closing costs when you eventually get a mortgage on the house.
For example, if you get a 30-year, fixed-rate mortgage for $380,000 (after making a $20,000 or 5% down payment on that $400,000 home), you’ll pay around $12,000 in closing costs in Phoenix, AZ, according to Bank of America’s closing costs calculator.
Alternatively, you could save the upfront fees you’ll pay on a rent-to-own deal, put that money in a savings account — or better yet, a mutual fund — and let it earn interest so you can afford to purchase a home sooner than you could in a rent-to-own deal.
4. You may lock in at a bad valuation
Like the price of gas, home values are constantly fluctuating. Sure, it’s true that, historically, home values increase over time because it’s an appreciating asset.
However, in the short term, list prices rise and fall by thousands of dollars within the span of weeks or months.
That can be a problem with the rent-to-own because most lease-purchase contracts state the agreed-upon sales price of the home in the contract. In other words, you’re locking in the price of the home one to five years before you buy it.
“It is possible for a rent-to-own contract to just set a purchase price range, but typically, you’re negotiating and locking in the price of the house long before you actually buy it,” explains Dang.
“If the property value has decreased when it comes time to purchase the house, the tenant is still locked in to pay the higher price.”
If the home value does decrease below the agreed-on purchase price, be prepared to lose the money you earned as a credit toward the purchase price. No bank is going to sign off on a mortgage for more money than the house is actually worth. So, unless you’re able to cover the difference, you won’t be able to purchase the property when your rent-to-own contract is up.
5. You’re on the hook for repairs to the house
Not only are landlords unlikely to make a profit-free rent-to-own deal, they’re also not thrilled about dumping money into fixing up a home they plan on selling soon.
Unlike standard rental contracts, the catch with most rent-to-own agreements is that they include conditions that say the tenant pays for all repairs and maintenance to the property.
This puts the responsibility for repairs and upkeep on you.
(While rent-to-own contracts do vary by state and could potentially put the responsibility for repairs on the actual homeowner, don’t count on it.)
At first glance, that seems like a reasonable arrangement. After all, you’re planning to own the home in the near future, so you’re probably happy to pay to have repairs done to your satisfaction.
However, this is a risky move, because there’s no guarantee that the deal will go through as planned.
What’s actually happening when the hot water tank bursts, the appliances break down, or the furnace fails, is that you’re paying to replace those items in a home you don’t legally own yet.
If you default on the lease, you won’t be able to buy the house — so you’ll lose the rental credit money and every penny spent making repairs and home improvements.
And it’s surprisingly easy to default on a rent-to-own agreement.
6. Late or missed payments for any reason could kill the deal
When you’re late with your rent in a standard rental agreement, the worst you’re looking at is a steep late fee (unless you’re a repeat offender and eviction is on the table).
No biggie, right?
If it’s a one-time situation due to unavoidable circumstances and you’re otherwise a stellar example of a pay-on-time tenant, then one late payment won’t do much damage. Your landlord may even be so understanding as to waive the late fees.
Honestly, a rent-to-own landlord may be that understanding, too. However, even if they are understanding and waive the late fees, a late payment may still void the rent-to-own contract.
“If you default on a rent-to-own contract, you go back to just paying regular rent and any money you’ve paid toward the price of the house is lost,” explains Dang.
And it’s not just late payments that are an issue. There’s a long list of scenarios that can trigger a default in a rent-to-own contract, such as violating a “no pets” clause, or failure to make required repairs in a timely manner.
Even if you’re a perfect tenant who’s followed the contract to the letter, there’s still a chance the rent-to-own agreement could be voided.
Let’s say you can’t afford to buy the house, or you fail to secure a mortgage, when the lease is up — don’t expect a refund. Failure to make good on the purchase nullifies the lease and that rental percentage credit you earned vanishes.
7. The rent-to-own setup is vulnerable to scams and shady landlords
As the tenant, you take on most of the risk in a rent-to-own contract.
You’re the one paying more than necessary in rent each month with the promise that the owner will credit the amount toward the purchase price someday. And you’re the one trusting that the money you spend on repairs is going into a home you’ll own someday.
Your landlord has very little risk because they remain the owner of the home throughout the lease. If you default, they get to keep the house and all the money you’ve paid.
The financial jeopardy you put yourself in is serious enough that the Federal Trade Commission issued a report that rent-to-own agreements can be shady deals and downright scams.
According to the consumer information report, defrauded rent-to-own tenants have found out too late that:
- the landlord can’t legally sell the house because he doesn’t actually own it
- the seller leaves you with several years of unpaid property taxes
- the house is in disrepair, or has hidden issues like lead or asbestos
- promised fixes aren’t made after a contract is signed
- the house is headed for or in foreclosure
Should you fall victim to one of these scams and an unscrupulous landlord, then at best you’ll have an unpaid tax bill. At worst, you’ll have spent years thinking you’re paying down the price of a home that you’ll never be able to purchase.
Don’t forget, these drawbacks apply to lease-purchase agreements; a lease-option contract could be a good deal for you if you negotiate well and it’s written with your interests in mind.
Lease-option and lease-purchase are sometimes used interchangeably, however they are two very different types of lease-to-own agreements. The lease-purchase obligates both parties to the future sale of the house with specific conditions.
The lease-option is simply that: a lease agreement with an option to buy down the road. A lease-option provides a limited option period, in exchange for an “option fee” paid to the seller.
This rent-to-own agreement never obligates the tenant to buy the property, but it does obligate the seller to sell at the agreed-upon price should the tenant trigger the purchase option within the specified option period.
If you’re interested in purchasing the house you’re renting, and your landlord offers you a rent-to-own contract that’s actually a lease-option agreement — don’t automatically say “no.”
Ask a real estate attorney or a top local agent with rent-to-own experience to review the contract first to determine if the lease-option is a good deal for you. If it’s not, another option is to lease a smaller, less expensive property and put the money you’ll save on rent toward building a down payment for your dream home down the road.
Header Image Source: (Holly Stratton/ Unsplash)