A lease-option, otherwise know as rent-to-own can be a great opportunity for people who don't have access to the traditional downpayment and mortgage path to homeownership. Maybe you can’t buy a home because of bad or no credit, limited funds for a downpayment, or both. However, lessee/buyers should be aware of the fact that it’s a complicated process with lots of terms, clauses, and risks. Even if you keep up your end of the bargain there’s still plenty that can go wrong.
Why the rent-to-own agreement is complicated.
The rent to own agreement is complicated because it’s a two-part contract that combines a lease and an option to buy the home. There's no standard rent-to-own contract so there can be as many terms as you and the lessor/seller decide are necessary to protect your interests. It will explain each party’s responsibilities and be the reference point in any disagreements so those terms should be negotiated until both buyer and seller have a deal they understand and are happy with. Because of all the variables, lessees/buyers should always seek legal advice from an attorney familiar with these kinds of deals. It may seem like an additional cost at a time they need to pay other bills or save for a downpayment but it’s far cheaper than losing all the money you put into the house after you've unintentionally broken one of the terms.
Warning: Some unscrupulous sellers may try to take advantage of your financial situation and try to dictate unfavorable terms. Just because you’re building or repairing your credit and don’t yet have enough for a full downpayment don’t let a seller bulldoze you into a bad contract. They could stand to gain from you failing to fulfill the contract so, as always; Buyer Beware!
The terms for a rent to own often include:
1. a non-refundable lump sum down payment that will go towards the purchase of the house if the lessee decides to exercise their option to buy. If the lessee chooses not to buy the house they will forfeit this money.
2. a monthly rent amount for the term of the lease. It’s often more expensive than you would pay for an equivalent rental. That's because a percentage of the monthly lease payment will often be a credit towards the purchase price. So a house that would have $500 a month rent under a standard rental model might be $700 in the rent-to-own model but $300 is going towards the purchase price so the rent is actually $400. If the lessee goes on to buy the house they were actually getting a break on the rent. If you choose not to buy the house they may be overpaying for the rent.
3. The lessee will pay for all the maintenance and repairs on the house as if they were the owner starting as soon as they sign the contract.
4. If the lessor/owner sees necessary repairs are not being done they can have them done and bill it back to the lessee.
5. If the lessee doesn't pay rent on time the contract could stipulate the lessee forfeits the option to buy the house, the original lump sum down payment, credits that were paid monthly, and all maintenance and repair costs.
6. The price of the house. It may be higher than the current market value because the lessee isn't buying the house right then. They are buying it at the end of the lease which may be several years in the future and the lessor/owner has to take the appreciation of the house into consideration.
7. What happens if you don’t pay rent on time? Did you break the contract after one incident or 10? Does the lessor/owner have to have the check by the first or the 5th of each month to be considered a strike against you?
8. If the lessee isn't ready to buy at the end of the lease because they haven't accrued enough money for a down payment or their credit isn't quite good enough yet to apply for a mortgage the contract should stipulate if they can renew the lease without losing all the money they've put into the house or whether they can’t renew and forfeit the option to buy and all the money they’ve laid out towards buying the house.
Why it’s good.
It allows you the exclusive right to buy a house at some point in the future so you won’t have to bid against the general public.
The price you’ll pay to buy the house is locked in so if prices skyrocket you won't have to worry about the house appreciating out of your reach.
*If house prices fall though the seller may not allow you to negotiate the price lower.
What could go wrong:
The lessor/owner can stop making mortgage payments and eventually lose the house to foreclosure. Then all of your good faith efforts were for nothing. Some unscrupulous owners may even know they’re going to stop making payments yet allow the lessee to make the initial lump sum upfront payment. In essence, scamming the lessee out of that money.
The owner could be sued or stop paying the taxes and a lien could be placed on the house.
What steps should I take before signing a Lease-Option Contract?
Lessee/buyers should approach the agreement as if they're buying the property.
Get a home inspection to find out what condition the home is in. It will cost from $400-$600 but is well worth the investment. The lessee will be responsible for maintenance and repairs from the signing of the lease and beyond, if they exercise the option to buy, so you want to know exactly what you're getting into. An inspector might find something big or they might find something small but the maintenance on a house is never $0. You'll want to negotiate any repairs that are needed and have them fixed before you sign or get it in writing that they will be financially responsible for fixing it in writing. If they refuse to pay for the repairs at least you know what you're getting into and can decide if it’s still worth it. You need to know what you need to budget each month for miscellaneous house costs. The owner might tell you it’s perfect but verify that. There's any number of structural and environmental issues that could be a deal-breaker. If you are responsible for the maintenance and it will need a new roof in the next few years do you still want to take that on?
Get a title search. It typically costs between $150 to $250 and will tell you if the person you're dealing with even has the right to sell the property or if there are any liens on the property.
Have the home appraised. The average cost for a single-family home is $300-$400. If the home appraises for less than you’re buying it for the bank won’t give you a loan. Then you’ll need to either have more cash for the downpayment to make up the difference, to renew the house on another lease, or walk away losing all option money.
The owner of the house should understand you're doing your due diligence on the property and should have no problems with any of these steps. If they are objecting and dragging their feet that may in and of itself be a red flag.
The Ultimate Goal
Always keep in mind the ultimate goal of a rent-to-own is to exercise your option to buy the house at the end of the agreement. That will mean you will have enough for the down payment and be in a position to be approved for a loan. You may choose to not exercise your option to buy for any number of reasons but, hopefully, not because your financial outlook hasn’t improved. As long as your finances have improved you can now go buy something else. To that end make sure you’re on the path to good credit and building a down payment before you sign the agreement. You should have a plan in place that you’re currently executing. Don’t sign the contract hoping somewhere down the line things will magically fall into place. There are many obligations you need to fulfill over a several year period to turn that rental into a home you own. Your discipline and hard work will pay off for you and you’re family but there might be many difficult choices you’ll need to make along the way. Your financial plan will keep you on track. If you’re not sure what to do consult a financial advisor. You may need just one or two consultations to get you headed in the right direction.