There are many ways for both sellers and buyers to both benefit from rent to own home arrangements. Rent to own contracts are not standard purchase contracts. The seller and buyer can write almost any clauses into the contract that meet their needs. However, there are Federal and local regulations that control some aspects of these contracts. One of the more important acts that informed investors/sellers should understand are the Dodd-Frank Wall Street Reform and Consumer Protection Act and the SAFE Act (dealt with mostly at the state level). You should consult with a qualified attorney in your state before proceeding. Remember there are state law disclosures, RESPA, Truth-in-Lending, and servicing rules to worry about, too.
Back in January 10, 2014, new mortgage underwriting criteria went into affect requiring a debt-to-income ratio of less than 43 percent for most qualified mortgages. The result is fewer potential buyers qualifying for a loan. Under the right conditions, rent to own homes become a good option for both the buyer and the seller.
Structuring the Contract
Rules vary from state to state but you can create a contract allowing lease options that benefit both the seller and the buyer. Typically, a lease option agreement allows the renter to buy the house within a set amount of time but doesn’t require him or her to make the purchase. Often the down payment, debt to income ratio, and credit history are the major obstacles preventing the want-to-be buyer from qualifying for a traditional mortgage.
The lease option agreement can be written so that the renter qualifies for a loan some time in the not too distant future (without the seller financing the purchase). The lease option can help the tenant/buyer overcome the common mortgage stumbling blocks by helping the buyer earn equity in the house. This can be done by charging a higher than market rate of rent and applying a portion of the rent towards the down payment (again, work with a qualified real estate attorney).
If the house is selling for $125,000 and $400 of the rent is applied towards the down payment, it will take about 5 years for the renter to accumulate a 20% down payment. If the lease option fee applies toward the down payment, needed equity will be in place sooner. Equity as a down payment, debt-to-income ratio, and credit score are common keys to obtaining a traditional loan.
Another option can include a version of seller financing. This is when the seller carries the mortgage instead of having the buyer qualify with a bank. Since the seller is going to want all of his money sooner rather than later, a balloon payment was often included. However, post-Dodd-Frank, many investors have relied on adjustable rate loans to entice buyers to seek future bank fixed refinancing.
The seller can help the buyer qualify for a traditional loan by reporting timely payments to the credit bureaus. Of course, the buyer needs to stay current with the payments or the seller will foreclose on the house in a seller financing arrangement. Or evict the tenant in a lease option arrangement that hasn’t been converted into a sale.
How the Seller Benefits
There are several ways the seller benefits from a rent to own contract. The first way is that typically the selling price of the homes is about 10% higher than the current market value. The buyer should accept the higher selling price for a couple of reasons. First, a lease option allows the renter to buy the home but doesn’t require him or her to buy. This means the seller has more risk than in a traditional sale (including not being able to offer the home for sale during the purchaser option period). Second, the house is most likely to be worth more money when the renter converts to a buyer at a future date (meaning it should appraise at or above the sales price).
However, rent to own home contracts need to have some built in protections for the renter as well. For instance, the current owner should not be allowed to take out a new mortgage on the property. The renter should also have the title checked to be sure there are no preexisting liens or encumbrances against the home.
While rent to own home contracts are a good tool for both sellers and buyers in today’s credit strapped economy, they are not without risk. Both parties to the transaction are best served by having a real estate attorney draw up the rent to own contract.
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Author bio: Brian Kline has been investing in real estate for more than 35 years and writing about real estate investing for 10 years. He also draws upon 30 plus years of business experience including 12 years as a manager at Boeing Aircraft Company. Brian currently lives at Lake Cushman, Washington. A vacation destination, a few short miles from a national forest. With the Pacific Ocean a couple of miles in the opposite direction.