Rent-to-own homes: How do they work?

Typically, when someone is looking to become a homeowner, they either have to take out a mortgage or have the cash on hand to buy the house outright.

However, rent-to-own homes offer an opportunity for people to become homeowners without taking this traditional route. Read on to learn what rent-to-own homes are, how they work, their potential benefits and possible pitfalls.

Key takeaways

  • A rent-to-own home agreement is a contract that allows you to rent a home with the option to buy it at the end of the contract term.
  • There are two types of rent-to-own agreements: lease purchase and lease option.
  • The Federal Trade Commission warns that it is important to educate yourself and that some rent-to-own home agreements may be scams, and it suggests that improving your credit and saving up for a down payment could be a less risky option.
  • Rent-to-own homes can benefit people who might otherwise struggle to purchase a home at the time.

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How does rent-to-own work?

Rent-to-own homes work a bit differently than your standard rental, even though you pay rent on a monthly schedule. The rent payment goes to the landlord to handle the expenses of owning the property.

Typically, when you sign a rent-to-own agreement, you:

  • Set a term of a certain number of years for the rental agreement.
  • Have the option—or obligation—to buy the house when the agreement ends.
  • Agree to pay money upfront toward purchasing the property.
  • Have money from your rent payments be used toward the purchase of the house.

Types of rent-to-own home agreements

There are two types of rent-to-own home agreements: lease purchase and lease option.

With the lease purchase agreement, you sign an agreement that you will purchase the home at the end of the term at an agreed-upon price.

With the lease option agreement, you have the right to walk away from the property at the end of the term. You can still agree to proceed with the purchase. However, you often pay a nonrefundable option fee when the agreement is signed—and if you don’t purchase the house, you might lose the option fee.

Pros and cons of rent-to-own homes

As with any financial decision, there are risks and benefits associated with a rent-to-own agreement. Keeping these in mind can help you make an informed decision before getting locked into a contract.

Pros of rent-to-own homes

Opting to join a rent-to-own home program can have a number of benefits for some individuals. These include:

  • A route to homeownership for people who might not qualify for a mortgage right away. This could be due to factors like low credit scores or difficulty saving up the 20% down payment recommended by the Consumer Financial Protection Bureau (CFPB).
  • A chance to test out the home before settling in more permanently, particularly if you’re using a lease option agreement.
  • The opportunity to pin down a particular home while you work on saving money for a down payment.
  • Time to address any issues that might have prevented you from purchasing the property outright.

Cons of rent-to-own homes

While there are benefits to rent-to-own homes, the Federal Trade Commission (FTC) warns about potential problems that can be encountered with this type of agreement:

  • You may find yourself agreeing to pay more than the value of the house at the end of the term.
  • You may be excluded from completing the deal if you missed any payments during the rental period.
  • The property may have liens on it if the landlord has unpaid property taxes.
  • You may end up paying higher monthly payments than you would simply by renting.

The FTC warns that some rent-to-own home agreements may be scams and suggests that improving your credit and saving up for a down payment could be a less risky option.

Is it cheaper to rent or own?

There are a number of factors that will affect whether it’s cheaper to rent or own a home. Factors like the value of the house and local property taxes can greatly affect the costs.

Renting means that you may have little or no responsibility for the maintenance of the home, which can save you money. However, you may have little or no control over rent increases, and you don’t build up equity in the property. You also don’t get the tax benefits associated with homeownership.

Owning a home means that you can build equity over time and have more control over how your property is maintained. However, as the homeowner, you’ll be responsible for all maintenance costs and property taxes. You also face the possibility of foreclosure if you fall behind on your mortgage.

Price-to-rent ratio

Using something called the price-to-rent ratio might help you decide which option is better for you. The ratio is a comparison of home prices to yearly rents. The higher the ratio, the better for renting. If you’re in a position to buy, it might make more sense to do so if the ratio is lower. A general rule of thumb is that it’s better to buy than rent if the price-to-rent ratio is 15 or less. Meanwhile, a price-to-rent ratio of 16 or above means it might be financially smarter to rent.

First, you’ll need to figure out the median home price and median rental price in your area. Then you can use this formula to figure out the ratio:

Price-to-rent ratio

Here’s an example using data from Austin, Texas. The median home price is $519,353, while the median rental price is $1,826. To calculate the price-to-rent ratio, you divide 519,353 by 21,912 (1,826 multiplied by 12) and get 23.7. Based on this ratio, it might be better to rent in this state capital. However, you could always take a closer look at individual neighborhoods for a more affordable area to buy in.

Rent-to-own homes in a nutshell

Rent-to-own homes offer people a chance to buy a house after a set rental period. This can help people become homeowners even if they don’t have the savings for a large down payment or if they have a poor credit history. However, homebuyers need to be aware that rent-to-own home agreements can be tricky to navigate and may not be right for everyone.

If you’re interested in learning about your options for renting or homeownership, check out these tips about how credit scores are related to renting an apartment and buying a home.

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