Rent-to-Own Homes: How the Process Works

If you’re like most homebuyers, you’ll need a mortgage to finance the purchase of a new house. To qualify, you must have a good credit score and cash for a down payment. Without these, the traditional route to homeownership may not be an option.

There is an alternative, however: a rent-to-own agreement, in which you rent a home for a certain amount of time, with the option to buy it before the lease expires. Rent-to-own agreements typically consist of two parts: a standard lease agreement and an option to buy.

Here’s a rundown of what to watch for and how the rent-to-own process works. It's more complicated than renting, and you'll need to take extra precautions to protect your interests. Doing so will help you figure out whether the deal is a good choice if you're looking to buy a home.

What Are Rent to Own Homes?

Rent-to-own homes are homes that include a clause in the rental agreement which either gives you the option to buy or an obligation to buy after a certain time period. You make rent payments each month and a portion of those payments can count toward your down payment. Should you decide to buy, the excess money can be applied to the home purchase.

Renting to own can be an appealing concept for people who are interested in owning property but have thus far been shut out of the traditional homebuying process. If you don't have a sizable down payment, for instance, or your credit score is too low to qualify for a mortgage, renting a property with the intention to buy it can give you time to save and work on improving your credit rating.

Nonrefundable Upfront Fees

In a rent-to-own agreement, you (as the buyer) pay the seller a one-time, usually nonrefundable, upfront fee called the option fee, option money, or option consideration. This fee is what gives you the option to buy the house by some date in the future. The option fee is often negotiable, as there’s no standard rate. Still, the fee typically ranges between 1% and 5% of the purchase price.

Lease-Option vs. Lease-Purchase

It’s important to note that there are different types of rent-to-own contracts, with some being more consumer friendly and flexible than others. Lease-option contracts give you the right, but not the obligation, to buy the home when the lease expires. If you decide not to buy the property at the end of the lease, the option simply expires, and you can walk away without any obligation to continue paying rent or to buy. This is not always the case with lease-purchase contracts.

To have the option to buy without the obligation to buy, it needs to be a lease-option contract. Because legalese can be challenging to decipher, it’s always a good idea to review the contract with a qualified real estate attorney before signing anything, so you know your rights and exactly what you’re getting into.

Steps to Buy a Rent-to-Own Home

Entering into a rent-to-own agreement typically means signing a formal legal contract. The contract should specify the terms of the agreement and whether you're obligated to buy the home or simply have the option to do so. There are several key pieces of information that a rent-to-own agreement should generally include.

Agreeing on the Purchase Price

Rent-to-own agreements should specify when and how the home’s purchase price is determined. In some cases, you and the seller will agree on a purchase price when the contract is signed, often at a higher price than the current market value. In other situations, the price is determined when the lease expires, based on the property's then-current market value. Many buyers prefer to “lock in” the purchase price, especially in markets where home prices are trending up.

Applying Rent to the Principal

You’ll pay rent throughout the lease term. The question is whether a portion of each payment is applied to the eventual purchase price. As an example, if you pay $1,200 in rent each month for three years, and 25% of that is credited toward the purchase, you’ll earn a $10,800 rent credit ($1,200 x 0.25 = $300; $300 x 36 months = $10,800). Typically, the rent is slightly higher than the going rate for the area to make up for the rent credit you receive. But be sure you know what you're getting for paying that premium.

Rent-to-Own Home Maintenance

Depending on the terms of the contract, you may be responsible for maintaining the property and paying for repairs. Usually, this is the landlord's responsibility, so read the fine print of your contract carefully. Because sellers are ultimately responsible for any homeowner association fees, taxes, and insurance (it’s still their house, after all), they typically choose to cover these costs. Either way, you’ll need a renter’s insurance policy to cover losses to personal property and provide liability coverage if someone is injured while in the home or if you accidentally injure someone.

Be sure that maintenance and repair requirements are clearly stated in the contract (ask your attorney to explain your responsibilities). Maintaining the property, e.g., mowing the lawn, raking the leaves, and cleaning out the gutters, etc., is very different from replacing a damaged roof or bringing the electrical wiring up to code. Whether you’ll be responsible for everything or just for mowing the lawn, have the home inspected, order an appraisal, and make sure the property taxes are up to date before signing anything.

Buying the Property

What happens when the contract ends depends partly on which type of agreement you signed. If you have a lease-option contract and want to buy the property, you’ll probably need to obtain a mortgage (or other financing) in order to pay the seller in full.

Conversely, if you decide not to buy the house—or are unable to secure financing by the end of the lease term—the option expires and you move out of the home, just as if you were renting any other property. You’ll likely forfeit any money paid up to that point, including the option money and any rent credit earned, but you won’t be under any obligation to continue renting or to buy the home.

If you have a lease-purchase contract, you may be legally obligated to buy the property when the lease expires. This can be problematic for many reasons, especially if you aren’t able to secure a mortgage. Lease-option contracts are almost always preferable to lease-purchase contracts because they offer more flexibility and you don’t risk getting sued if you are unwilling or unable to buy the home when the lease expires.

Treat the process the same as you would if you were outright buying a home: Do your due diligence, research the area, compare prices with other nearby homes, research the contract, and research the seller's history.

Who Are Rent-to-Own Homes Right for?

A rent-to-own agreement can be an excellent option if you’re an aspiring homeowner but aren’t quite ready, financially speaking. These agreements give you the chance to get your finances in order, improve your credit score, and save money for a down payment while “locking in” the house you’d like to own. If the option money and/or a percentage of the rent goes toward the purchase price, which they often do, you also get to build some equity.

While rent-to-own agreements have traditionally been geared toward people who can’t qualify for conforming loans, there’s a second group of candidates who have been largely overlooked by the rent-to-own industry: people who can’t get mortgages in pricey, non-conforming loan markets. “In high-cost urban real estate markets, where jumbo (nonconforming) loans are the standard, there is a large demand for a better solution for financially viable, creditworthy people who can’t get or don’t want a mortgage yet,” says Marjorie Scholtz, founder and CEO of Verbhouse, a San Francisco–based start up.

“As home prices rise and more and more cities are priced out of conforming loan limits and pushed into jumbo loans, the problem shifts from consumers to the home finance industry,” says Scholtz. With strict automatic underwriting guidelines and 20% to 40% down-payment requirements, even financially capable people can have trouble obtaining financing in these markets.

“Anything unusual—in income, for example—tosses good income earners into an ‘outlier’ status because underwriters can’t fit them neatly into a box,” says Scholtz. This includes people who have nontraditional incomes, are self employed or contract workers, or don't have a U.S. credit history (e.g., foreign nationals)—and those who simply lack the huge 20% to 40% down payment banks require for nonconforming loans.

High-cost markets are not the obvious place you'll find rent-to-own properties, which is what makes Verbhouse unusual. But all potential rent-to-own home buyers would benefit from trying to write its consumer-centric features into rent-to-own contracts: The option fee and a portion of each rent payment buy down the purchase price dollar-for-dollar, the rent and purchase price are locked in for up to five years, and participants can build equity and capture market appreciation, even if they decide not to buy. According to Scholtz, participants can “cash out” at the fair market value: Verbhouse sells the home and the participant keeps the market appreciation plus any equity they’ve accumulated through rent “buy-down” payments.

Before You Sign the Contract

Signing off on a rent-to-own agreement can create certain legal obligations both for you and the property seller. Here are a few additional tips to consider before you sign.

Choose the Right Terms

It's important to read the fine print on a rent-to-own agreement to understand whether it's lease-option or lease-purchase. Again, a lease-purchase agreement could put you in the position of being forced to buy the home, which may be problematic if you find later that you're unable to afford it or don't want to own it.

Get Help 

Hiring a qualified real estate attorney to explain the contract can help you understand your rights and obligations in a rent-to-own agreement. You may want to negotiate some points before signing or avoid the deal if it's not favorable enough to you.

Research the Contract 

Rent-to-own contracts can be complicated and it's vital that you understand all the finer details. For instance, take time to review:

• The deadlines (what is due when)
• The option fee and rent payments–and how much of each applies toward the purchase price
• How the purchase price is determined
• How to exercise your option to buy (for example, the seller may require you to provide advance notice in writing of your intent to buy)
• Whether pets are allowed
• Who is responsible for maintenance, homeowner association dues, property taxes, and the like
• What "maintenance" means: just mowing the lawn and raking, etc. or serious repairs, such as fixing a roof.

Research the Home 

It's essential to perform certain due diligence before buying any home, including rent-to-own properties. Ordering an independent appraisal, obtaining a property inspection, making sure the property taxes are up to date, and ensuring there are no liens on the property can help you make an informed decision about whether you should buy the home.

Research the Seller 

Working with the right seller can make a rent-to-own experience a positive one and it's helpful to look into the property owner's background before committing. For instance, you may want to check the seller’s credit report to look for signs of financial trouble and obtain a title report to see how long the seller has owned the property—the longer they’ve owned it and the more equity, the better.

Ask the Right Questions

If there's anything you're unsure of with a rent-to-own agreement, it's better to ask questions sooner rather than. later. For instance, it's a good idea to know under which conditions could you lose your option to buy the property. Under some contracts, you lose this right if you are late on just one rent payment or if you fail to notify the seller in writing of your intent to buy.

The Bottom Line

A rent-to-own agreement allows would-be home buyers to move into a house right away, with several years to work on improving their credit scores and/or saving for a down payment before trying to get a mortgage. Of course, certain terms and conditions must be met, in accordance with the rent-to-own agreement. Even if a real estate agent assists with the process, it’s essential to consult a qualified real estate attorney who can clarify the contract and your rights before you sign anything. And if you decide that you'd like to buy outside of a rent-to-own agreement, it may be helpful to compare the best mortgage rates to find a great deal on a home loan.