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Rent-To-Own Real Estate Full Of Pitfalls

If you’re at a place in your life where you’d really rather not be living in an apartment but you don’t have the money to buy a home yet, an in-between option can get your foot in the door faster. It’s called “renting-to-own” or a “lease option.” Before you consider this type of arrangement, you should be aware of how it works, who benefits and the many things that can go wrong.

How You Can Rent to Own

In a lease option you rent a property at a cost slightly above market rate. Prior to moving in, you agree on a potential purchase date and purchase price for the home. You may buy the property at any point during the rental period up until the lease option expires. The lease option period can be any length of time that you and the seller agree to, ranging from several months to several years.

If you do purchase the property, the seller will credit part of your rent back to you, usually more than the portion of your rent that was above market rate. You can put this money toward a down payment and closing costs, or keep it. The purpose of the above-market rent is to give the seller an incentive to complete the transaction. If you do not purchase the property, all of the rent you paid remains with the seller, giving the seller an incentive for taking the property off the market during the time you were renting it.

Note: Not all states allow lease options on residential property, so the buyer should ensure that the contract is legal.

How It Benefits Sellers

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One of the main reasons why a seller might be interested in a rent-to-own arrangement is because if an owner is having trouble selling, rent-to-own provides an alternative to lowering the home’s price, taking the home off the market, or renting the home out long term. Because a selling price is established in the lease-option contract, the current homeowner knows exactly what to expect if a sale goes through. If the market declines slightly during the lease period, the sale price is already locked in, but the tenant will probably still be interested in buying the property because of the rent money rebate. Meanwhile, the owner gets help paying the mortgage, property taxes and insurance. Also, unlike a traditional rental agreement, the tenants are more likely to take care of a lease-option property because they have the option to purchase it.

How It Benefits Buyers

The main reason why a rent-to-own agreement appeals to buyers is a financial one. If buyers don’t yet have the down payment or the monthly income to qualify for a mortgage but believe they will within the next couple of years, a lease option allows them to accelerate the path to homeownership. By signing a contract now, the buyer locks in a purchase price, which means no worrying about rising home prices. (Note: In a rapidly appreciating real estate market, the seller of a lease-option property would probably want to add a clause to the contract allowing for the price of the home to increase with the market.)

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The buyer also does not have to worry about coming up with the money for property taxes, private mortgage insurance or homeowners insurance, and the seller will usually continue to pay for and complete any maintenance and repairs on the home. Finally, by living in the home before deciding to purchase it, a buyer has the advantage of a lengthy test drive on the home before jumping into a major financial commitment. Best of all, if the buyer decides to walk away from the deal, the only consequence is the loss of that portion of the rent paid that was above market rate. If the buyer ends up purchasing the property, the seller will credit part of the rent back to the buyer, often more than the portion of rent that was above market rate.

Potential Pitfalls for Buyers

Of course, everything doesn’t always come up roses with lease options. A would-be buyer should be aware of the many things that can go wrong in the process before getting involved in a rent-to-own agreement. Before entering a rent-to-own agreement, a potential buyer should:

1. Check the seller’s credit report. Look for potential warning signs that the seller is in financial trouble, such as delinquent accounts or a large amount of outstanding debt. Even after a satisfactory credit check, a potential buyer who currently lives in the home should still pay attention to any warning signs that would indicate that the seller is in financial distress. Some examples include phone calls from debt collectors and suspicious-looking notices that are sent to the house.

2. Recognize that the seller could lose the property during the rental period. This could occur for any number of reasons such as if he or she is unable to make the mortgage payments, a tax judgment is placed on the property, he or she goes through a divorce, is being sued and so on. If the seller loses the property, the potential buyer loses the possibility of buying the property, forfeits the extra rent paid and will have to find a new place to live. There is one possible exception: If the home becomes bank-owned through foreclosure, the bank might consider selling the home as soon as possible to the rent-to-own buyer in order to avoid the hassle of maintaining and marketing the property to a different buyer. In this case, the rent-to-own buyer would have to decide whether the purchase is feasible at the new date.

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Obligations of Tenants and Landlords Under a Rent-to-Own Agreement

Here are a few ways lease agreements with a lease-option component vary from traditional leases.

Payment of Rent and Setting Aside Monthly Rent Payments Varies

Just as in a standard lease or rental agreement, the tenant has a duty to make timely and exact payments of rent. In a rent-to-own arrangement, rent payments are often higher than they would have been had the transaction been a standard lease agreement. This is because an agreed-upon percentage of the monthly rent is typically placed in an escrow account. It is the landlord’s duty to set aside the agreed-upon percentage of rent. The landlord either reserves the escrow funds and refunds the tenant upon purchase of the home, or simply applies a percentage of the rent payments toward the principle of the house. In this manner, the tenant builds equity in the house throughout the duration of the lease agreement.

Tenant Makes Necessary Repairs to the Rental Property

Unlike a traditional lease, in which the landlord is typically responsible for making all repairs, rent-to-own tenants usually repair the rental property at their own expense. Many landlords and tenants consider this a fair bargain since, presumably, the tenant will eventually own the home.

Tenant Must Fulfill Lease Obligations

Until the tenant exercises the option and purchases the rental property, the premises are owned by the landlord. So, in addition to making repairs, the tenant must also comply with all other duties outlined in the lease. This means that the tenant must not have pets if the lease prohibits pets, must not house unauthorized residents, must not engage in criminal activities, and must not do anything else that is forbidden by the lease. If the tenant violates the lease, the option will become null and void. The tenant will likely forfeit both the option fee and the percentage of the monthly rent payments, depending on the terms of the option-to-purchase agreement.

The Tenant Should Inspect the House and Order an Appraisal.

Although the tenant may never exercise the option to purchase the rental property, tenants should always inspect the premises

and order an appraisal before signing a lease with an option to purchase. Here’s why:

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  • The future purchase price of the home is often agreed upon at the time the rent-to-own agreement is signed. An appraisal will ensure that the tenant is paying a fair price for the home.

  • A thorough inspection can determine whether the tenant will need to make future major repairs such as those to restore leaking roofs, broken HVAC and heating units, or clogged sewage drains, and help the tenant make the decision of whether entering into the agreement is sensible. In some states, landlords who lease a home with an option to purchase must disclose important information about the condition of the property, providing extra protection to tenants who are buying a home under a lease-option agreement.

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Rent to Own Homes: an Option to Consider?

When the term "rent to own" pops up, it's not always clear what it means, and that's partially because renting to own and the similar plan lease/option can work numerous ways. However, in a typical scenario, tenants can rent for a set period, such as a year, then when that time is up, they have the option to purchase the home. A portion of the rent is often credited to the sales price or closing costs.

Tenants may also purchase the option to buy the property for a predetermined price at the end of their lease by putting down a (non-refundable) payment of about 3 percent. With this option in place, the tenant is not bound to purchase at the end of the lease, but meanwhile, the property owner can't sell to anyone else.

Plans like this can appeal to people with little or no savings for a down payment, or people with bad credit or no credit who don't qualify for traditional mortgages. The latter group can include those who lost their homes in foreclosures, according to real estate investor Barb Getty, who has had both positive and negative experiences with rent-to-buy contracts.

Renting to own is also a way to get into a desired neighborhood in a timely matter, as with parents who need to be in school district for their kids, or people who are uncertain of their timeline, according to San Francisco real estate professional Herman Chan. "It's a way to get into a house without committing to a 30 year mortgage," he said.

It's not a very common practice. Of the 609,482 sales transactions on record in San Diego from 1990 to the present that were conducted with a real estate agent, only 782 were completed with a lease option contract, according to the San Diego Association of Realtors.

Let's take a look at the pros and cons. For those doing the lease option rental, the primary benefit to the buyer is that or or she can lock in a price, according to Phil Georgiades, the chief loan steward for VA Home Loan Centers in California.

However, there are numerous concerns and potential drawbacks that make rent to buy more complicated and often more expensive than straight renting. Among them: the tenant's rent payment will likely be higher than market rent as part of that will be going toward the eventual down payment on the property. This extra amount will be forfeited if the tenant doesn't act on the option to buy.

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Why Sell With Rent to Own?

Sellers can also benefit from rent to own arrangements.

More buyers: If you’re having trouble attracting buyers, you can also market to renters who hope to buy in the future. Not everybody has good credit and can qualify for a loan, but everybody needs a place to live.

Earn income: If you don’t need to sell right away and use the money for another down payment, you can earn rental income while moving towards selling a property.

Higher price: You can ask for a higher sales price when you offer rent to own. You’re providing an opportunity that people may be willing to pay for. Renters also have an “option” to buy the house — which they might never use — and flexibility always costs extra.

Invested renter: A potential buyer is more likely to take care of a property (and get along with neighbors) than a renter with no skin in the game. The buyer is already invested in the property and has an interest in maintaining it.

How It Works

Everything is negotiable: A rent to own transaction, also known as a lease option, starts with the contract. Both the buyer and seller agree to certain terms, and all of the terms can be changed to fit everybody’s needs. Depending on what's important to you (whether you're a buyer or seller), you can request certain features before signing an agreement.

For example, you might request a larger or smaller up-front payment if that would be helpful for you


Advice is essential: Be sure to review any contract with a real estate attorney because these transactions can be complicated, and there is a lot of money involved. Rent to own deals are especially risky for buyers. Several scams take advantage of people with poor credit and high hopes of buying a home. Even with an honest seller, it’s possible to forfeit a lot of money if things don’t go as planned.

An option to buy: At the beginning of any rent to own transaction, the buyer pays the seller an option premium, which is often around five percent of the ultimate purchase price (although it can certainly be higher or lower). This payment gives the buyer the right or “option” — but not the obligation — to buy the home at some point in the future.

No refunds: The initial premium payment is non-refundable, but it can be applied to the purchase price (if the buyer ever buys the home, she won't have to come up with as much cash). Larger option payments are risky for buyers: if the deal doesn't go through for whatever reason, there's no way to get that money back. The seller typically gets to keep any premium payments after a rent to own transaction ends.

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Purchase price: The buyer and seller set a purchase price for the home in their contract. At some point in the future (usually between one and five years, depending on negotiations), the buyer can purchase the home for that price — regardless of what the home is actually worth. When setting the price, a price that’s higher than the current price is not uncommon (otherwise, the seller is better off just selling today). If the home has gone up in value faster than expected, things work out in the buyer's favor. If the home loses value, the renter probably won't buy the home (partly because it might not make sense, and partly because the renter might not be able to qualify for a large loan with a high loan-to-value ratio). Buyers usually apply for a mortgage when the time comes to purchase the home.

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Monthly payments: The buyer/renter also makes monthly payments to the seller. Those payments serve as rent payments (because the seller still owns the property), but the renter typically pays a little bit extra each month. The additional amount is usually credited to the final purchase price, so it reduces the amount of money the buyer has to come up with when buying the home. Again, the extra rent "premium" is nonrefundable — it compensates the seller for waiting around to see what the buyer will do (the seller can’t sell the property to anybody else until the agreement with the renter ends).

Maintenance: Everybody involved benefits from a well-maintained home, but who should pay? Your agreement should specify who is responsible for routine maintenance and extensive repairs. Some agreements say that anything under $500 is the responsibility of the buyer, but local laws can complicate matters (landlords might be required to provide certain amenities, even if your agreement says otherwise).

Rent to Own Statistics

According to the Federal Trade Commission survey on rent to own consumers, 2.3 percent of households have participated in rent to own transactions. Of that 2.3 percent, 4.9 percent participated them in the last 10 years.

The survey, conducted in the year 2000 represents the entire rent to own industry. That includes people who rent to own furniture, electronics and other purchases. It is not limited to the rent to own home industry.

Almost 80 percent of people who rent to own are between the ages of 18 and 44, according to the same survey.

Sixty-seven percent of people who rent to own intend to purchase the product at the end of the lease and fifty-eight percent of people who rent to own actually purchase.

While the majority of people who rent to own eventually purchase the products they are renting, there is still a large chunk of people who rent to own that do not purchase the home.

That is the reason why the option fee is so important for renting to own homes. The seller is committing not to sell the property to anyone while you are leasing it because he or she has the expectation that you will purchase the home at the end of the lease and he or she will receive the full value of the home in cash. If you end up not purchasing the home the seller does not get the money. The seller’s time has been wasted.

The option fee serves as an incentive for a buyer to go through with purchasing the home and a consolation for a seller who ended up not selling his or her home.

Factors Influencing Consumer Opinions About Rent to Own

Twenty-seven percent of all rent to own customers complained about high prices for rent to own products. That complaint makes a lot of sense. Renting to own is considerably more expensive than buying outright. It can cost more than plain renting too.

If you rent to own a home at $1,000 a month for 2 years and then purchase a home for $100,000. You have essentially paid $124,000 for the home – 24 percent more than people who buy outright.

People do it because they cannot afford the down payment on a $100,000 home when they start the lease. Or, they do not qualify for a mortgage quite yet.

For someone who cannot yet purchase a home, the extra $24,000 would have been spent on rent regardless. Therefore, the added expense of rent to own is nonexistent because if the person was able to purchase a home at the time, they would have.

The tricky part is when rent premiums and option fees come into play.

An option fee can be anywhere between one and five percent of the total cost of the home. Therefore, on the theoretical $100,000 home, the option fee would be between $1,000 and $5,000.

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The option fee makes renting the home more expensive, but it does not make the purchase price more expensive. You see, if you purchase the home, you will still be paying $124,000. The only difference is that you will have a $1,000-$5,000 credit applied to your down payment.

However, if you end up not purchasing the home, you do not get the credit, so instead of $24,000 for 24 months of rent, you paid $29,000 for 24 months of rent. That’s almost 21 percent more than fair market rent.

Then you factor in rent premiums which may be in your contract. For example, you may have paid $1,100 a month, in exchange for a $200 credit each month toward your down payment. In this situation, you would have a $4,800 credit toward the down payment of your home in addition to the option fee.

However, like the option fee, if you choose not to purchase the home, your rent would be $2,400 more expensive than fair market rent. Rent premiums are a good deal for people who purchase the home, but the added expense can make some customers disgruntled.

What Do These Facts, Figures and Statistics Mean

In general, renting to own is not the best option. When you have enough cash and a good credit score, you should not rent to own. However, many people do not fall into this category. For that reason, rent to own remains a viable option for many people interested in taking steps toward owning a home.

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