Ask Brian is a weekly column by Real Estate Expert Brian Kline. If you have questions on real estate investing, DIY, home buying/selling, or other housing inquiries please email your questions to [email protected].
Question. Curt from Mississippi asks: Hey Brian, I’m 23 and have absolutely no experience buying a home other than occasionally reading your column and a few other articles. I’ve heard of rent-to-own homes. These sound like a great idea to me since I’m already paying rent but also interested in buying my first home. Can you tell me how these work along with the pros and cons?
Answer. Hi Curt. Rent-to-own is catchall phrase for several possible ways that a renter can become a homeowner. First of all, it’s a creative way to both buy and sell a home. Creativity can be great for experienced buyers and sellers (especially investors) but first time buyers need to use extreme caution because the process can be very different from the way most people traditionally buy a home. Most first time buyers get some valuable advice from parents, friends, or someone they trust. Because rent-to-own doesn’t follow the traditional model, your trusted sources aren’t likely to know much about the process. Especially, what is considered normal and acceptable in this nontraditional process.
With that said, buying a house isn’t really any different from entering into a financial contract for anything else. What you most want or need from a deal can dictate the terms and conditions that you look for. When you go shopping for a new car, you might want a certain model, best gas mileage, best financing terms, lowest payments, or to lease instead of purchasing. Creative financing for real estate is a lot like that. It doesn’t have to follow the traditional business model of negotiating a purchase price and taking out a 30-year mortgage. People use creative financing every day to buy real estate. It can be an all cash deal, seller financing, a land contract, or one of many other arrangements including rent-to-own.
The important part is that you fully understand what you are signing up for. With a rent-to-own contract, you will NOT be using traditional (boilerplate) contracts. The contracts will be written to meet the unique needs of both you and the seller. Since you are young and inexperienced at buying real estate, it’s strongly recommended that you have a competent real estate attorney review and explain the paperwork to you before you sign it.
Curt, you specifically asked about rent-to-own but there is another version that you need to be aware of. That is the lease with an option to purchase. There is a significant difference. With a rent-to-own, you are generally committing to the purchase from the very beginning. You agree to a purchase price and specific contract terms. The details in the contract terms are critically important. The seller/owner is going to apply a specific amount of your monthly rent towards the down payment. The rent amount is almost certainly going to be above the market rate. The owner/seller is somewhat acting as both your landlord and banker to help you save money. At some point (typically 2, 3, 5, 7, or 10 years), a balloon payment will come payable by you. Most people will need to take out a mortgage to make the balloon payment. There is also the possibility of seller financing once the accumulated extra rent reaches a predetermined threshold. At that point, you become the owner of the home on the title and make monthly payments to the seller until the home is paid in full or a balloon payment comes due. There is considerable risk that you won’t take ownership of the house. You might not be able to qualify for a mortgage when the balloon payment comes due. There may be a clause in the paperwork stating that the extra rent amount doesn’t apply towards the down payment if the rent is paid late. Or any of many other variables that you need to be fully aware of and comply with.
If you don’t comply and/or meet all of the contractual requirements by specific dates, the rent-to-own agreement will lapse. The seller/owner will keep all of the extra money you have put into the deal but you won’t become the homeowner. Because you have signed an agreement to purchase the home, the seller/owner could sue you for breach of contract. Chances are that the owner/seller will want you to move out so he/she can look for another rent-to-own buyer or otherwise sell to someone who can qualify. Again, it’s critically important that you have the contract reviewed by an attorney and fully explained to you. You also want to have a high degree of confidence that you’ll be able to successfully complete your obligations in the contract.
The lease with an option to purchase is similar but has a few important differences. Foremost, when you originally sign the paperwork, you are not fully committing to purchase the house. You can walk away at any time. You’ll pay an “option fee” that gives you’re the right to purchase the home by a specific date. Until you complete the purchase or that specific date arrives, you’ll be leasing the home. That option fee applies towards the down payment but only if you complete the purchase. You’ll probably have to qualify for a mortgage to complete the purchase. If you don’t complete the purchase by the specified date, you’ll forfeit your option fee to the landlord/seller. The purpose for the option fee is to give you an “exclusive right” to purchase the home. During the option period, the landlord/seller cannot sell the house to another person. Not even for more money.
Generally, people prefer the lease with an option to purchase for one of two reasons. One is to “test drive” the house. You can live there a year or two to learn if the house suits you needs, learn about the neighborhood, and be sure there aren’t any problems with the house that you don’t want to own. The other reason typically deals with qualifying for a mortgage. Maybe you want to lock in the price of the house at today’s price but expect it will take you another year or two to qualify for a mortgage. Maybe you need to improve your credit score or maybe you need to be with the same employer for at least two years. There can be other reasons that you can’t immediately qualify but will soon be able to. Again, the risk to you is that you’ll lose your option fee rather than have it apply towards the down payment if you don’t complete the purchase on time. Also again, talk to an attorney before signing any paperwork. There can be many variables in the terms and conditions. One relatively common variable is to make you responsible for most of the repairs and maintenance during the lease period. If you don’t complete the purchase, you could out of this money also.
Curt, I hope you found this useful but it is really just the tip of the iceberg when it comes to possible variations in the contract. Almost anything can be included or excluded as long as you and the seller agree. Ideally, the two of you come to a meeting of the minds that is a win-win for both.
As a reader, what would you add as important to know about a rent-to-own or lease with an option to purchase arrangements? Please leave your comment.
Our weekly Ask Brian column welcomes questions from readers of all experience levels with residential real estate. Please email your questions or inquiries to [email protected].