Should You Rent-to-Own a Home?

If you want to buy a house, but don’t qualify for a mortgage or have money for a down payment, a rent-to-own agreement may be a good option.

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Rent-to-own is exactly what it sounds like – you rent a home with a contract that allows you to eventually buy it.

There are benefits and disadvantages to rent-to-own, and whether it’s a good idea depends on your financial situation. Some may decide a better option is improving their credit score and paying down debt until they’re in a financial situation where they can buy.

The median sale price for a single-family home at the beginning of 2022 was $353,900, which means a 20% down payment of $78,780, which is a heavy financial lift for most consumers. Lower-income buyers have the option of an FHA loan, with a 3.5% down payment of $12,386, but that’s still a stretch for many budgets.

Even lower-priced homes are expensive, once insurance, interest, maintenance and other costs are thrown in.

Take a look at how rent-to-own works, the benefits and disadvantages, and what alternatives there are if you don’t qualify for a mortgage but want to buy a home.

What Is Rent-to-Own?

Rent-to-own typically is used by people who want to own a home, but aren’t in an immediate financial position to do it.

With a rent-to-own agreement, the renter may have an option to buy, or may commit to buy, once the term of the contract, usually 1-3 years, ends. In most cases, the contract includes the agreed-to sale price of the home.

A typical rent-to-own candidate may be someone like Maria. She was out of work for a while and maxed out her credit cards. Now she has a new job with a good salary, and would really like to buy a home.

Rents in her area are high – she’s paying $1,300 for a one-bedroom apartment. But the housing market is hot, too. She needs to improve her credit before she can get a mortgage, but she doesn’t want to lose out on a house as prices continue to rise.

After contacting a local real estate agent, Maria found a rent-to-own home that she liked. Her monthly payment is $1,800, with $1,300 of that going to rent – the same amount she was paying for her apartment – and $500 going toward the down payment. When the 24-month deal ends, she’ll have paid $12,000 toward the down payment. She has an option to buy the house for $250,000, so that would be enough for the FHA mortgage she’s hoping to get.

In the meantime, she’s also entered a debt management program to reduce her credit card debt, raise her credit score and save more money. By the time the two-year term of her agreement expires, Maria will be in a great position to get a mortgage to buy the house.

Other reasons a rent-to-own may be appealing are you may be new to the city and want time to be sure you like the area or you just started your job and the lenders wants evidence it’s going to be permanent.

What Is in a Rent-to-Own Agreement?

There are two types of rent-to-own agreements:

Lease option. The renter has the option to buy at the end of the term, but doesn’t have to.

Lease-purchase. The renter is required to buy at the end of the term.

While the specifics of rent-to-own contracts differ, most include:

  • A nonrefundable upfront premium payment, usually 1% of sales price, that locks in home price and other terms, and is applied to the down payment.
  • The monthly payment, both rent and the “rent credit” – the amount that is applied to the down payment.
  • The time limit, or term, of the agreement, including whether it can be renewed.
  • Who is responsible for maintenance, insurance and other costs during the contract term.
  • Purchase price. This is often higher than current market rate, since the owner needs some incentive to hang onto the house rather than selling.

Most contracts allow the landlord to keep the rent credit money, even in an option agreement, if the renter decides not to buy. Some contracts have either a premium payment or a monthly credit. Every contract is different. Be sure you understand yours before you sign it, and be prepared to walk way, if it doesn’t work for you.

Price to Rent Ratio

One way to determine if entering a rent-to-own agreement is a better idea than renting is by using the price-to-rent ratio. Google the median home price in your area, then divide it by what you pay annually for rent. The rule of thumb is that if the ratio is 15 or higher, buying may be a good option.

As an example, the median price for a home were Maria lives is $250,000. Her $1,300 a month in rent adds up to $15,600 yearly. When the median home price is divided by the annual rent, the price-to-rent ratio is 16. So, Maria determined she’d pay less monthly if she bought a home for $250,000. Of course, this doesn’t take into account the other expenses that go into home ownership, like insurance and maintenance.

Rent-to-Own Pros & Cons

It’s wise to weigh the advantages and disadvantages before entering a rent-to-own agreement.

Rent-to-Own Pros

One of the biggest benefits of a rent-to-own agreement is that it gives the renter a start on building equity, which traditional renting doesn’t do. Equity is the money left over between a home’s value and what’s owed on the mortgage. While the renter isn’t actually building equity, once the sale goes through, that’s money towards paying for the house.

The best rent-to-own candidate is someone, like Maria, who has short-term bad credit that they know they can improve. Rent-to-own gives the renter time to improve bad credit while locking in a home to buy. This only works if your credit improves enough to get a mortgage by the end of the agreement’s term.

Other rent-to-own benefits:

  • You get a chance to “test drive” the house and neighborhood, so you know what you’re getting when you buy.
  • You’re putting money every month toward a down payment with the rent credit.
  • You already have dibs on a house and know the price, a big benefit if the housing market in your area is hot.

Rent-to-Own Cons

Disadvantages of rent-to-own mostly apply if the “own” part doesn’t pan out. The renter could lose any money paid toward the down payment, whether it’s an option or purchase deal.

Some of the other disadvantages:

  • The rent is higher than the local market, sometimes by as much as 10%-15%, because it includes the rent credit.
  • If the contract calls for you to be responsible for maintenance and repairs, it can be expensive.
  • A rent-to-own agreement doesn’t make you any more qualified for a mortgage than you were before. If you don’t qualify for a mortgage when the agreement term expires, you can’t buy the house.
  • If the owner doesn’t pay his mortgage or taxes, you may have to move out and the agreement may be moot.
  • If you have a lease-purchase agreement and can’t buy the house when the time comes, you could be in legal and financial trouble.
  • If the local housing market slows down, you are still locked into a price that may be more than the house is worth.
  • If you don’t pay your rent on time, the seller can terminate the agreement.
  • Rent-to-own agreements can be a way to scam the unsuspecting. Do your homework before you sign on.

Effect on Credit Score

A credit score shows how well you use credit and pay your bills. Your creditors report your monthly payments and credit use to the three credit bureaus. Landlords don’t generally report to the bureaus, so a rent-to-own agreement won’t help your credit score. Or hurt it.

That said, you can ask the landlord if they’ll report your payments. If they agree to, be sure to pay on time or your credit score will go down and so will the odds of buying the house when the time comes.

Alternatives to Rent-to-Own

Owning a home is the best way for many people to build solid financial footing, not only for themselves, but for their children. It’s the biggest investment you’ll likely ever make, and building equity, something you can’t do when you’re renting, is how that investment pays off.

Equity is the number one way that moderate and lower-income Americans can build wealth, which means financial security and freedom to pursue education, careers, better health care and more.

So, the bottom line is that you want to buy a home in a way that makes financial sense. Rent-to-own is a good option for people who know they’ll be able to buy in the near future, but that’s a financial tightrope for many people.

If you don’t want to take that chance, there are ways to put yourself into position to buy a home outright, even if you don’t make a lot of money.

Mortgages for Lower-Income Buyers

The U.S. Department of Housing and Urban Development has many programs for moderate and low-income homebuyers. Most HUD programs are administered through state housing authorities. Every state has one, and HUD has a webpage that links to them.

FHA loans are the primary HUD homebuying program. They require a 3.5% down payment for credit scores 580 or higher. If it’s lower, the down payment is 10%. There are also other requirements to qualify, including a steady income.

Your state housing authority also has information on VA loans, USDA loans and other options for people with low and moderate incomes.

Be a Smart Renter

Remaining a traditional renter while you work on your credit doesn’t mean you’re throwing money away. Being a smart renter will also help you save money. Some tips are:

  • Ask your landlord to report your rent payments to the credit-reporting agencies – this will help build your credit score (if you pay your rent on time).
  • Understand your lease, including what’s required to get your security deposit back.
  • Renter’s insurance costs about $350 a year and is a good investment, covering your belongings if they’re stolen or there’s a fire.
  • Don’t be afraid to demand your landlord keep up with repairs and maintenance – this protects your health, safety and quality of life.
  • Look for lower-cost options, like a roommate or rental assistance so you can save and pay down debt.

Credit and Homebuying

Whether you’re ultimately going to go for a traditional mortgage, which requires a 620 credit score or higher, or an FHA loan or other option that allows lower scores, improving you credit should be your number one goal when looking to buy a home. It’s never too early to start. The higher your credit score, the more options you have when it comes to getting a mortgage.

Start improving your credit score right now by paying your bills on time and reducing credit card balances, the two biggest factors in determining your credit score. Creating a monthly budget is the best way to make sure you can do that and save for a down payment.

Credit Counseling and Debt Management

If you want to improve your credit, but don’t know where to begin, contact an accredited nonprofit credit agency. Agencies accredited through the National Foundation for Credit Counseling offer free credit counseling that includes help with budgeting, review of your finances and suggestions on how to tackle debt. They may also suggest home-buying resources and programs. They are fiduciaries, which means they’re required by law to give advice that’s in your best interest.

Contacting and using the services of a credit counseling agency will not hurt your credit or appear on your credit report. In the long run, it can help your credit score improve.

The counselor may suggest debt management, which is a way to consolidate your credit card payments to pay the balances down more easily. You make one fixed monthly payment, and they work with your creditors to get lower interest rates. A DMP takes 3-5 years to complete and has a $40 monthly fee that’s included in your monthly payment.

A credit counselor may also suggest a Credit Card Forgiveness program, offered by a select few nonprofits. If you qualify, 40%-50% of your credit card balances are forgiven. You make a fixed payment over 36 months, paying off 50%-60% and the rest is forgiven.

Improving your credit through your own hard work, which may include debt management or credit card forgiveness, may seem like a long haul, but it will be worth it. Buying a home is an investment that can vastly improve your long-term financial standing and overall security. It’s not something you want to enter into lightly. Taking the time to get on track will pay off in the long run.

Bottom Line

Rent-to-own is a legal contract between the renter and the person who owns the property. Before entering into the agreement, be sure you understand it and it works for your situation and your goals. If it doesn’t, then rent-to-own isn’t a good option.

Look at entering into a rent-to-own agreement as though you are buying a house, with all the caution and homework you’d do in that situation.

Some tips if you’re considering a rent-to-own agreement:

  • Consult a real estate lawyer to review the contract.
  • Discuss your mortgage qualifications with a lender, so you’ll know what you have to do to qualify for a mortgage by the end of the rent-to-own agreement term.
  • Review your finances and create a strategy to improve your credit and save for the home purchase. Don’t put it off thinking you have until the end of the contract to figure it out.
  • You’d get a home inspection before buying a home, so get one before committing to a rent-to-own deal.
  • Ask for a seller’s disclosure, including insurance claims on the property and title review before you sign a rent-to-own agreement.

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Sources:

  1. Elmi, S.; Lopez, B. (2021, November 30) Foundations of a New Wealth Agenda: A Research Primer on Wealth-Building for All. Retrieved from https://www.aspeninstitute.org/publications/foundations-of-a-new-wealth-agenda-a-research-primer-on-wealth-building-for-all/
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