On the surface, a rent-to-own real estate deal might seem like a good idea, but here’s why experts think rent to own can be bad for buyers and the approach to take instead. —-
You’ve been looking into the rent-to-own process, and on the surface, it seems like a good idea. It appears to be a great situation if you are already renting; why wouldn’t you put your hard-earned money toward eventually buying, instead of feeling like you’re throwing your cash into a black hole to keep a roof over your head?
There are many reasons that a prospective homebuyer could be interested in renting to own. Maybe your credit score could use some polishing, you aren’t quite sure where you want to buy, or you still have those pesky student loans to pay off (ahem, all millennials!) and don’t want to get into more debt.
Whatever the reason might be, you’re not alone — but before jumping into rent-to-own with both feet, you should understand the potential risks. After talking with agent expert Armand Lencheck, who works with 74% more single-family homes than the average agent in his area of Chapel Hill, North Carolina, we’ve compiled a list of 13 reasons why rent-to-own can be a bad situation for buyers, and also provided some alternatives to get your foot in the door of your first home.
The reality of rent-to-own
When looking into rent-to-own contracts, the first thing you might notice is that a “standard” rent-to-own contract doesn’t exist. The rent-to-own process varies by state, and these contracts are usually written by legal advisors working with the buyers and homeowners.
In general, a rent-to-own contract usually covers a time period of between 12 and 24 months — this is the time that you will rent the home before actually buying it. The rent-to-buyers will usually pay an “option fee” when they move in, which is typically 1% to 7% of the purchase price. This fee gives you the first “option” to purchase the house; it is typically non-refundable and is a sign of good will that the tenant is seriously interested in buying the property at the end of the contract.
When the time comes to buy, the option fee is usually applied to the down payment. If the buyer decides not to buy the house, then the seller keeps the option fee.
As a potential buyer, you will usually pay market-rate rent plus some agreed-upon additional funds each month that will also go toward your down payment. This additional monthly payment is usually refundable if the buyer backs out, although the rent portion of that fee is not.
The purchase price of the home is usually set in the rent-to-own contract when you move in, not at the time you buy the home, so you typically can’t negotiate the sales price after you have rented for the term of your contract.
On top of all this, unlike a more traditional landlord-tenant scenario, the buyer is usually responsible for maintenance to the home prior to the purchase.
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So: Why is rent-to-own bad for buyers?
Let’s discuss some more specific reasons why renting to own can be a bad idea for buyers and what the alternatives might be.
1. Lease purchase vs lease option
All rent-to-own contracts are different depending on the specific situation; some contracts are “lease purchase” rather than “lease option” agreements. A lease purchase agreement means the buyer is obligated to purchase the house instead of reserving the first option to buy it.
Even if you are confident that this is the home for you, and that you should have the money to buy it at the end of the contract, there are always events that could change your mind. What if you get your dream job (and it’s located across the country), or what if you or a member of your family has a health emergency and you have to move? Heck — what if there is a global pandemic and your financial circumstances change!
If you’re totally sold on the idea of rent-to-own, don’t consider lease purchase agreements and insist on a lease option agreement instead — because if the past few years have taught us anything, it’s that you never really know what will happen in a year or two.
2. The purchase price might be inflated when the time comes to buy
Rent-to-own contracts will usually stipulate how much you’re going to pay to buy the house at the beginning of your contract, so the buyer is effectively locked into that purchase price. The buyer and seller will agree on a price at the start of the contract based on what the market is doing then, and they might not get it right!
The price documented in the contract could be much higher than the home’s market value at the time of purchase, which could be a problem when it’s time for a real estate appraiser to come into the picture — a bank won’t loan more money than a house is worth.
Before signing a rent-to-own contract, talk to a market expert (like a real estate agent) to get their opinion about how the market is growing, or shrinking, to land on a price that you think is fair.
3. You’ll still need to repair your credit and accrue some savings
Let’s be honest — there is usually a reason why rent-to-own sounds like an appealing idea, and that is typically because you don’t have your ducks entirely in a row to buy a home today. You might need a higher credit score to get a mortgage, or save a bit more for a down payment.
Renting-to-own isn’t a get-out-of-applying-for-a-mortgage-free card — you’ll need to secure financing later, when you do buy the house, at the end of the contract. This means that you have a fixed amount of time to get your finances in shape if they need a little TLC, and there isn’t any guarantee that you’ll be approved for a mortgage when the time comes to buy.
Instead of getting yourself into a situation that could be financially detrimental, be vigilant about improving your credit score and saving the money you’ll need to buy a home, and wait for the right time. There is no pressure to buy a home immediately (no matter what your dad might say!).
4. You’re paying more than market value in rent
Don’t forget: there’s no rent-to-own without “rent.” Most of what you will be paying every month is just that, rent. The additional amount agreed upon between the buyer and seller in the contract will go toward your down payment — but remember, you are still paying monthly market-rate rent to the seller until you buy, and that money will not go toward your down payment, and won’t be refundable if you back out of the deal.
If you are already struggling financially, paying more than market value in rent every month might not be the best fiscal move. So if you are getting into a rent-to-own agreement, make sure that you’re not spending more than you can afford, and get an opinion from a financial advisor on the amount you are paying in rent and what’s going toward your down payment vis-a-vis your income and savings.
5. You’ll still need to save up for the down payment
The option fee that you pay at the beginning of your contract and the extra money you’re spending on rent every month will put a dent in your down payment — but it’s unlikely to get you a large down payment.
Think of it this way: If you are in a rent-to-own contract for one year, and the house you are buying will cost $200,000, the option fee will be 1% of that purchase price ($2,000). Then, if you are paying $500 in additional rent each month, by the end of the year you’ll have paid an additional $6,000, for a grand total of $8,000 toward your down payment.
That’s 4% of the home’s total purchase price — not bad by any means, but nowhere close to the 20% you’ll need to plunk down on a conventional loan if you want to avoid private mortgage insurance.
You’ll have to cut corners elsewhere and make sure you’re saving up as much as you can to get the mortgage that you want when it comes time to buy. If you are turning to rent-to-own because you are low on funds for your down payment, some viable alternatives might include down payment assistance (grants and loans), asking friends and family for help (double check loan gifting guidelines), or see if you can qualify for a USDA or VA loan (0% down) right now instead of waiting.
6. You probably won’t get all your extra investment back
Remember, there are three payments that you will make toward your home during your rent-to-own contract: the option fee (non-refundable), monthly market-rate rent (non-refundable), and the additional money that you pay per month, which goes toward your down payment (usually refundable).
That said: Beware of additional fees! The seller might stipulate in the contract that they are charging an additional “convenience fee” on top of all the rest for allowing you to rent, and then purchase the home at a later date. The seller has the right to keep your option fee, your monthly rent, and any additional convenience fees — this could mean money you’re spending that isn’t going toward your down payment; you’ll never see it again. Make sure that you’re clear on how much you’re going to get back, the potential situations under which the seller could keep all your money, and then determine whether it’s worth it to you.
7. If you decide not to buy the house, you’ll lose money
If for whatever reason (ahem, a global pandemic!) you decide to back out of the deal, you are almost certain to lose your option fee — and you might even lose the additional money you’re putting toward the down payment, depending on what is written in your contract.
Pretty certain that rent-to-own will be the best solution for you? Look into programs like Divvy, which have a rent-to-own mentality but do give you your money back if you decide to walk away. In many cases, it will make most financial sense for you to wait, save, repair your credit, and buy a house when you and your bank account feel ready.
8. You may be on the hook for repairs
Many rent-to-own contracts stipulate that the renter will handle any repairs to the home from the time you move in. This could include anything from fixing a leaky sink to installing a new roof.
If you’re already stretching to make your rent and additional payments, will you realistically have the funds for maintenance and repairs? Instead, before you sign your contract, talk to the seller about adding a stipulation that you will split costs, or make sure you can really afford to repair and maintain the house before you actually buy it.
Lenchek says: “You need to determine who is responsible for the major maintenance of this house versus the minor maintenance of this house. It has to be specifically agreed upon in the contract, or there will be big arguments later.”
For a glass half full scenario: if you (the buyer) are responsible for the maintenance of the house, then you have complete control over the quality of the repairs and which contractors you can hire. If the house you are planning to buy does need a large repair, like a new roof, it could give peace of mind to the buyer to oversee that construction. That is of course, if you have the savings to make it happen.
9. When mortgage rates are low, waiting can be costly
We’ve said it before and we’ll say it again: You just can’t know for certain what will happen in a year or two. In 2021, mortgage rates are historically low, but in a rent-to-own situation, there is no guarantee what your mortgage rate will be when you apply for one when you’re ready to buy — and when mortgage interest rates rise, your purchasing power decreases proportionally.
See if you can get financing with today’s rates to buy a home. If you have a good amount of money saved, it might be easier than you think to buy a home now instead of waiting in a rent-to-buy contract, and you might qualify for low down payment programs, especially if you are a first-time buyer!
10. If you’re late with one payment, the whole deal could be over
Many rent-to-own contracts stipulate that if the buyer is late on their monthly payments, even once, they no longer have the option to purchase the home, lose their option fee, and potentially also lose the extra rent they’ve been paying.
Before signing your contract, you need to make sure you’re clear on what happens if you are late on one or more rent payments, and exactly when the rent is due every month. Be sure to also note any reasons for eviction listed on your contract.
Lenchek says: “What we have found is that there are a lot of sellers out here in the marketplace who get that non-refundable deposit, and then turn around and look for excuses to evict the buyer from the house. That’s the biggest red flag [in the rent-to-own field] — the sellers of the home are looking for the smallest excuse, the smallest infraction against the lease to use against the buyer to evict them from the house, pocket that substantial part of the down payment and then put the house back on the market to be sold, or, rent it out again under the same terms.”
Before you sign anything, make sure that the lease isn’t just geared to meet the needs of the seller, and that it is fair to you as a renter as well.
11. If the homeowner stops making their payments, you’ll lose the house
A truly horrific rent-to-own scenario is if you are making all your monthly payments on time, but the seller isn’t.
Rent-to-own deals are usually between two private, individual households, and you don’t necessarily have a clear picture into the seller’s finances when you sign the contract. Ideally, they are taking your rent payments and paying their own mortgage with it … but you have little or no guarantee that they will.
Because the house isn’t yours until you actually buy it, if the seller stops making mortgage payments on the house, the bank can foreclose — no matter what kind of deal you made. In this situation, even though the seller would owe you the option fee and other additional payments, it could be very difficult to get your invested money back without going to court and paying legal fees.
In this case, working with a company can be a more sound investment than an individual; in any event, make sure your contract stipulates what the owner’s payment responsibilities are, so that you have some legal grounds to stand on if they take your option fee and rent and take off to Mexico.
12. The house might not be in peak condition
Often, a seller’s reason for starting a rent-to-own deal is because the property has been on the market for a long time without any offers. The owner could be occupying it or renting it to tenants — or it could have been left vacant for some time.
Depending on how well the most recent occupants kept up with it, it might be in great shape, or it might require some fixes. In a rent-to-own scenario, get a home inspection before you sign anything (and definitely before you move in) as you would during a more traditional home purchase. Make sure to ask your home inspector if they recommend any additional specialized inspections for things like pests, radon, or mold.
13. Rent-to-own can be scammy!
Unfortunately, there are a lot of bad deals out there claiming to facilitate rent-to-own purchases! Many states don’t acknowledge rent-to-own as a standard home-buying practice, and there are no standard contracts in this field — rent-to-own is an area flagged by the Federal Trade Commission for a reason!
There are many reasons that rent-to-own contracts can fall through, leaving little protection for the investments of buyers or sellers.
Before getting lured in by the rent-to-own concept, do your research and work with an expert, like an agent or a real estate lawyer, who can help protect your interests, and who has your best financial interest in mind.
If you are dead set on renting-to-own, above all else, remember to advocate for yourself, do your research thoroughly, and hire experts who can point out potential issues you could run into on the road to rent-to-buy.
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