How Does "Rent to Own" Work?
Rent-to-own requires tenants to lease a property for a certain period of time, while giving them the option to purchase the home before the lease runs out.
February 28, 2022
Unfortunately, these two requirements make it challenging for many people to become homeowners. In a recent survey of 2,000 US adults, 42% said their low income has inhibited their efforts to buy a home, and 37% said they don’t have enough saved for a down payment.
For those unable to purchase real estate, the only other option is to rent. But what about rent-to-own? Are rent-to-own homes legit?
This guide will explain how rent-to-own works and how you can rent to own your next property.
What does rent-to-own mean?
Rent-to-own is a type of legal agreement that allows you to buy a home after you rent it for a period of time.
In most cases, you will sign a rent-to-own agreement that involves:
Renting/leasing the home for a certain period of time (usually 1 to 3 years)
Paying a bit over the market rate for the rental
The extra money you pay builds up to become your down payment if you choose to buy
At the end of the lease, you can choose to buy the home or move out
Some agreements require you to buy; others simply give you the option
Many agreements require an “option fee” of 2 to 7% of the home’s value at the time of signing
Rent-to-own exists to give renters a path towards homeownership. It’s also a way for homeowners and companies to increase their income, as these agreements typically produce higher rent revenue per month than standard rentals.
There are two different types of rent-to-own agreements, which we’ll cover in more detail below.
Types of rent-to-own agreements
In figuring out how to rent to own, it’s very important to understand the type of agreement you are signing, as they differ substantially. Here are the details of each type:
A lease-option agreement gives you the option, but not the obligation, to purchase the home after the lease period. Lease-option agreements typically do not set a firm price for the eventual house purchase. Instead, you will get an appraisal and negotiate with the homeowner at the time of purchase.
These agreements typically involve an upfront fee, called the “option fee,” of around 2 to 7% of the home’s value. For a $300,000 home, that’s anywhere from $3,000 to $21,000 due at the time of signing.
Fortunately, most agreements allow you to apply the option fee to the eventual purchase of the home. So if you do decide to purchase, that option fee should reduce the amount of the purchase price of the home — but be sure to check the fine print.
These agreements also include higher-than-average rent prices for the property. The premium you pay over normal rent price goes towards your future down payment.
At the end of the agreement, if you choose not to buy, you simply walk away — but remember that you will forfeit the rent premiums you’ve paid, as well as the option fee.
To illustrate, let’s look at an example.
You sign a rent-to-own agreement on a 2-bedroom house that has a fair market rent of $1,200/month
The lease agreement requires a 2% option fee, with an estimated home value of $300,000. This means you will pay $6,000 at the time of signing for the option fee
Your agreement requires you to pay $1,600/month, with the extra $400 per month going towards your future down payment
You sign a 36-month (3-year) agreement, and live in the home for the entire 3 years
During this time, you will earn approximately $14,400 in “rent credits” which can be applied to your future down payment (the extra $400/month that you have paid), and your initial $6,000 option fee can also apply to your down payment
After 3 years, you decide to buy. You have approximately $20,400 in credit built up towards a down payment, and you can apply for a mortgage to cover the remaining cost
You will negotiate the purchase price with the owner, get an appraisal, and purchase the property
Keep in mind that every agreement is different in its specific terms and conditions. It’s recommended to consult with a real estate lawyer before signing a rent-to-own agreement.
A lease-purchase agreement is similar to a lease-option agreement, but the main difference is that you are required to purchase the home at the end of the lease term.
In this type of agreement, you and the seller formally agree to a purchase price for the property ahead of time. You then sign the lease, rent the property for X years, and then purchase it at the agreed-upon price.
There’s typically no loan option fee with this type of agreement. However, if you do not buy the home — or you can’t qualify for a mortgage — the seller can sue you for breach of contract.
When rent-to-own might make sense
Rent-to-own is not for everyone. In fact, if you’re ready to buy a home through a traditional route, rent-to-own typically does not make financial sense.
That said, rent-to-own can make sense in some situations, such as:
If you need time to improve your credit score before applying for a mortgage
If you need time to save for a down payment
If you struggle to save and would benefit from the forced-saving nature of a rent-to-own agreement
If you do enter into a rent-to-own agreement, be sure that you’re confident that you actually want to purchase the home — and that you’ll be able to get a mortgage when the time comes.
If you aren’t confident that you’ll be able to buy, or that you’ll want to buy, consider sticking to renting.
This also means that if you don’t have the best credit right now, make a plan to improve it while you’re renting.
A good way to improve your credit is to pay off existing debt and lower your debt to income ratio.
Tally† might be able to help. Tally is an app offering a lower-interest line of credit, that helps qualifying applicants consolidate credit card debt and potentially pay it off faster. Learn how Tally works here.
Unfortunately, there are some scams and shady companies in the rent-to-own space, so renters need to be cautious.
You may see companies advertising deals that seem too good to be true, like rent-to-own homes with bad credit and no down payment. Remember that most agreements still require some money upfront, usually in the form of an option fee.
Other situations are outright scams, where someone who doesn’t actually own the home attempts to “sell” it in a rent-to-own scheme. Other scams exist too — renters should be aware of any potential rent-to-own scams before researching opportunities.
Finally, it’s important to do your research on how to rent to own safely and effectively. If you can, consult with a lawyer or real estate expert before signing any agreement.
†To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. Based on your credit history, the APR (which is the same as your interest rate) will be between 7.90% - 29.99% per year. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 - $300.