You’ve probably heard the term “rent-to-own” used with consumer products like furniture or cars, but it can apply to homes, too. If you’re a renter and have your sights set on buying a house down the road, a rent-to-own agreement is one path to get there.
If you can come up with a small down payment, buying a home outright with an FHA loan may be a better option. Read on for the benefits and drawbacks of rent-to-own.
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What is ‘rent-to-own’?
Rent-to-own, otherwise known as a lease purchase, is a legal contract between a buyer (you) and a seller to purchase a house with a future closing date, usually one to three years after the contract is signed.
This is different from a lease option, in which you’re given the choice to buy the place you were renting — before the home goes on the market — but are under no contractual obligation to do so.
In a rent-to-own agreement, you pay a deposit fee (usually around $5,000) plus rent and “rent premiums.” Your rent payments go toward the seller’s mortgage, and the premium payments become your down payment when it’s time to buy the home from the seller.
Why should I consider it?
This kind of arrangement might work for you for a few reasons. The first, and most likely, is it gives you time if you don’t have enough cash for a down payment, which can be as little as 3.5% or as much as 20% of a home’s sale price. Renting to own lets you get the house you want while letting you save up the down payment and closing fees involved in a purchase.
» MORE: How much house can I afford?
Also, getting the agreement in writing now means you lock in the purchase price at today’s value, rather than gambling on whether it will go up or down while you save a down payment.
Finally, there’s something to be said for having part of your monthly payment benefit you instead of only paying your landlord’s mortgage, as you would in a traditional rental agreement. For example, if your premium fee is $500 per month, after a year that would amount to $6,000. Add that to your $5,000 deposit, and you already have $11,000 saved for the down payment after your first year in the agreement.
What are the disadvantages?
A rent-to-own agreement is a legally binding contract and, as with any contract, you have to be able to deliver. If you can’t follow through with the home purchase when the rental time is up — for instance, you can’t qualify for a mortgage because of credit problems — you’ll lose your initial deposit and could face legal consequences. Also, because you were paying rent and a rental premium, you’ll have paid considerably more to rent a home than you would have in a typical rental.
While it’s in your favor to lock in the price before it goes up, home values can also plummet. Sellers typically don’t use rent-to-own unless it’s been difficult for them to get offers, and it can be hard for you to get a favorable deal. You might even see a loss if home values slip or if mortgage rates go up before it’s finally time to buy.
Deciding if it’s right for you
A rent-to-own situation can be tricky if it’s not well thought out. Because there’s no standard contract for this arrangement and every state has its own regulations, it’s important to talk to a real estate attorney to make sure you fully understand the terms and responsibilities. A real estate attorney or title company can also verify that the house isn’t in foreclosure and there are no problems with the property title.
Lastly, find out if the home needs major improvements. If it does, try to negotiate a lower purchase price. If you decide to make improvements and then are unable to purchase the home once the rental period is up, you probably won’t recoup that money — and the seller will have a better-looking home that can be sold to someone else for more money.
Comparing your options
If you’re comparing a rent-to-own opportunity with a more conventional home-buying process, you may find it useful to calculate what your mortgage payment would be. It might not take as much of a down payment as you think to get an affordable mortgage payment.
More from NerdWallet:
How to choose the best mortgage
Compare mortgage rates
How to decide it’s time to buy a home
Deborah Kearns is a staff writer at NerdWallet, a personal finance website. Email: email@example.com. Twitter: @debbie_kearns.
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