In this article, you will find a review of the concept of rent-to-own and how it works, along with the advantages and disadvantages that buyers and sellers may face.
Definitions and Examples of Rent-to-Own
Rent-to-own allows potential buyers to rent a property with an option to purchase it later. The contract gives the tenant the option to buy the home at a specified point in the future. Part of the monthly rent goes toward the purchase price of the home, allowing the renter to save for a down payment. Buyers typically pay a non-refundable option fee, often up to 5% of the purchase price.
How Does Rent-to-Own Work?
The buyer and seller agree on a purchase price for the home in the contract they enter into. At some future point, the buyer can purchase the home based on that price – regardless of whether the actual value of the home is higher or lower than that.
It is common to set the rent-to-own home price higher than the market price to anticipate potential increases in home value. If the home price appreciates faster than expected, it is favorable for the buyer. If the value of the home decreases, the tenant can walk away. Buyers typically apply for a mortgage when it’s time to buy the home.
Remember that there are two types of rent-to-own agreements. Option agreements allow the tenant to purchase the home at the end of the rental period. Purchase agreements require the tenant to follow through with the purchase.
Buyers usually pay an upfront option fee or equal installments linked to the rent payment, often up to 5% of the final purchase price. The option fee is non-refundable but can be applied toward the down payment.
The contracts also specify the monthly rent amount plus any additional amount the tenant pays each month. The additional amount is typically credited toward the final purchase price, reducing the financial amount the buyer needs to save when buying the home. The additional rent is non-refundable. The seller compensates for not selling the property to anyone else until the end of the agreement with the tenant. Contracts should also clarify who is responsible for maintenance during the rental period.
Is Rent-to-Own Worth It?
Rent-to-own agreements make sense for some buyers but not for others. If you have unstable credit or need time to save for a down payment, rent-to-own might be the right option for you. Much depends on your financial situation and the state of the housing market.
Price-to-Rent Ratio
The price-to-rent ratio measures the affordability of purchasing versus renting in the housing market. It is calculated by dividing the median price of homes sold over a specific time frame in a given market by the monthly average rent for the same market over 12 months.
For example, the median price for homes sold in the United States during the fourth quarter of 2021 was around $423,600, while the average monthly rent during the same time across the largest fifty metros was $1,771. So, to get the price-to-rent ratio, you would divide $423,600 by $21,252 ($1,771 × 12) and get 19.2, with a higher ratio indicating that the market is more favorable to renting. The market is more favorable to buying the lower the ratio.
Of course, home prices and rents vary in each market, so the national average only provides a broad overview. To be precise, your calculations should be based on current figures in the location where you plan to purchase or rent a home.
Advantages
Pros and Cons of Rent with Option to Buy for Buyers
Advantages
-It allows buyers who cannot qualify for a home loan to begin purchasing a home with a rent-to-own agreement. Over time, they can work on rebuilding their credit scores and may be able to secure a loan when it’s time to buy the home.
-Buyers in markets experiencing rising home prices can lock in a purchase agreement at today’s price while completing the purchase in a few years. This allows buyers to walk away from the deal if home prices drop, although how economical it is financially will depend on the amounts they paid under the agreement.
-Buyers can live in the home before committing to buying it, so they can check for problems with the house, nightmare neighbors, and any other issues before it’s too late.
-Buyers who are committed to the home and neighborhood (but unable to purchase) can move into a home they will eventually buy. This reduces the cost and hassle of moving after a few years.
-Although renters do not build equity the same way homeowners do, payments can accumulate and provide a significant amount that can be used to purchase the home in the future.
Disadvantages
-If you do not purchase the home, you will lose all the additional money you paid. Sellers may be tempted to make it difficult or unappealing for you to buy so they can keep your investment.
-You may plan to improve your credit or increase your income to meet loan conditions by the time the option expires, but things may not go as planned.
-You do not have actual ownership of the home yet, so you do not have full control over it. The landlord may stop making the initial mortgage payments and lose the home in bankruptcy proceedings, or you may not have the authority to make major maintenance decisions. The landlord may also lose the title or stop paying property taxes, leading to liens on the property. Agreements should address all these scenarios. The landlord does not have the right to sell the property to anyone else while you have an option on the home, but legal battles are always a source of major headaches and expenses.
-Home prices may decrease, and you may not be able to renegotiate a lower purchase price. In this case, your options will either be to forfeit all the money tied up in your option or purchase the home. If the lender does not approve a surplus loan, you will need to add more money in case of the purchase.
-According to your agreement, if you do not pay rent on time, you may lose your purchase option as well as all additional payments. In some cases, you may retain your option, but the additional payment for that month will not be counted and will not be considered as part of the amount saved for later purchase.
-There could be issues with the home that you may not be aware of until you try to buy it, such as title problems. You should treat the rent-to-own process as a real purchase. Conduct an inspection and research the title before engaging in the deal.
Advantages and Disadvantages of Rent with Option to Buy for Sellers
Advantages
-If you are having difficulty attracting buyers, you can target renters who hope to buy in the future.
-If you do not need to sell immediately and are using the money for another down payment, you can earn rental income while moving towards selling the property.
-You can
Request a higher selling price when offering rent with an option to purchase. People may be willing to pay more for the opportunity.
– Tenants also get the option to purchase the home – which they may never use – but flexibility always costs more.
– Tenants/buyers have a vested interest in maintaining the property and understanding neighbors more than renters who have no stake in the game. The tenant/buyer has an investment in the property and needs to maintain it.
Disadvantages
– The tenant may not purchase, which means starting everything over and finding another buyer or renter – at least you can keep the extra money.
– You do not receive a large amount of double money, which you may need to buy another home.
– You lose the opportunity to benefit from the increased value of the home. The selling price is usually secured when signing the lease with the option to purchase, but home prices can rise faster than expected. You have to accept this or wait for a while before offering the purchase option.
– Home prices may drop and you may not be able to renegotiate a lower selling price. In this case, you would be forced to either forfeit all the relevant option money or buy the home. If the lender does not approve a large loan, you will need to inject additional money into settling the down payment.
– According to your agreement, if you do not pay rent on time, you may lose the right to purchase along with all the additional payments. In some cases, you might retain your option, but this month’s additional payments will not count and will not be added to the amount saved for later purchase.
– The home may have problems you were unaware of until you try to buy it, such as title issues. You should treat the rent-to-own process as a real purchase. Conduct an inspection and research the title before engaging in the deal.
There are many possibilities in rent-to-own deals. The seller and buyer agree on certain terms, and all terms can be altered to suit everyone’s needs.
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Source: https://www.thebalancemoney.com/what-is-rent-to-own-315664
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