Imagine finding a home you absolutely love (or at least see a lot of potential in). Now: What if you could live there, but instead of spending your savings up front, you pay a little portion on top of your rent each month towards the down payment. Sounds like a dream, right? Most likely yes—especially if you're a freelancer, have so-so credit, or a high debt-to-income ratio (those damn student loans!), or simply can't put enough cash aside every month to make way on a down payment.
Well, this situation isn't just the stuff of dreams—it's a type of contract known as "rent-to-own." But like many too-good-to-be-true scenarios, it comes with a fair share of risks to consider. Here's what you should know before you sign:
What is a rent-to-own lease?
These unicorn-type leases are called many things, but "rent-to-own leases," "lease-purchase contracts," "lease-purchase agreements," or "lease-to-buy options" are commonly used. In a rent-to-own lease, a tenant agrees to rent a unit or house from a landlord. Each month, the landlord will stow away part of the monthly payment towards the tenant's fund in the home. The agreed-upon price stays fixed throughout the lease. Usually, once the tenant has paid enough equity in the home to qualify for a mortgage, the tenant has the option to buy from the landlord.
For example, a tenant may sign a lease-purchase contract for a $150,000 house. The landlord will require them to put $500 down and pay $1,200 a month—$200 of this will go towards a down payment. After two years, the tenants will have paid $4,800 towards the down payment, or 3.2 percent of the property value—enough to cover a down payment on an FHA mortgage. If they so chose (remember, it's the option to buy), the tenant can secure the mortgage and follow the standard home-buying proceedings.
Though this sounds like a great set-up, rent-to-own leases aren't always so magical.
For one, they can be expensive. Landlords may require non-refundable upfront fees (known as an option premium) in order to secure the option to buy. They can end up being just as costly as a down payment—if not more. The standard is usually 5 percent, but this can be negotiated between parties. Additionally, if a tenant chooses not to buy at the end of the contract, they will not get any of the stowed away money back.
It's also important to note that rent-to-own leases sound similar, but are very different from "contract for deed" set-ups (which have their own set of risks). Contract for deeds are seller-financed homes where a buyer pays a seller back over a long period of time in monthly installments with high-interest. In these situations the tenant is responsible for all repairs, and usually taxes and insurance as well.
In rent-to-own, the tenant is usually covered by tenant law during the rental period and isn't liable for maintenance or repairs. However, this can vary from state to state—and your landlord may try to have you sign away these rights (though, again, the legality of this varies from state to state).
What are some of the risks of a rent-to-own lease?
Because homeownership is becoming out of reach for more Americans, rent-to-own leases are becoming more popular. There are now some well-funded Wall Street companies that offer transparent rent-to-own programs for renovated, high-end homes. Additionally, they're common in peer-to-peer sales, like if a family friend wants to sell their property to you, but you don't have full-financing yet. However, according to Nichole Monticelli, a real estate agent at BEX Realty in Florida, the standard rent-to-own contract are almost always written with the seller's best interest in mind—that means when getting into them as a tenant, you need to do your due diligence to mitigate risk.
For example, landlord/sellers may try to have all maintenance and repairs fall on the tenant (this can be against tenant laws in many states, so check with your attorney!) Or a contract may state that a single late payment will void the agreement. This means the tenant would lose any money they've already paid as well as the money they've put into renovations and repairs on the property.
And since rent-to-own leases are appealing to those who are otherwise pushed out of traditional home buying options, the market is susceptible to scams. For example, Florida saw a rise in scams involving rent-to-own leases during the housing market crash of the mid-2000's, says Monticelli. There were many cases where the tenants were making their monthly payments, completing repairs, and even upgrading the home while the property owners pocketed their payments. The owners would then stop making the mortgage payments and the tenants would find themselves high and dry when the banks came to reclaim the property. A 2016 "New York Times" investigation showed these scams were on the rise again.
If you find a rent-to-own opportunity, keep an eye out for some of these red flags:
- If the home is in bad shape, this may indicate that it was neglected, has already been foreclosed on, or is in the process of being reclaimed by the bank.
- Beware of a landlord who discourages you from having an independent inspection and appraisal done.
- Your extra payments should add up to the agreed down payment amount: "Typically we're talking about a 3.5 percent down payment for an FHA-insured mortgage," Holden Lewis, a home expert at NerdWallet, says.
- Check the title report to verify that your landlord is the legal owner of the property, says Shaolaine Loving, attorney at Loving Law LTD. The report will also detail any additional liens or judgments that would have to be paid before you take ownership (and likely the landlord would require you to pay for them).
However, even if all of these things get the all-clear, it's important to realize that you're still entering into a shaky situation—you're investing in something you have little control over.
For example, though there may not have been any additional liens against the property when you signed your lease, the owner may have added some after the fact, says Loving. Determining if this is the case, and trying to protect yourself against it, will all come at an additional cost to you. This can make the true cost of purchasing a home through a rent-to-own lease much higher than that of a traditional purchase.
Additionally, though you do have legal rights to the money you invested, it might be very expensive to get what you're owed in extreme cases: "The owner can still default in their mortgage obligations and lose the home to foreclosure," Loving says. "[This] would put you in the bind of having to litigate for any remedy against the seller."
What to do before you sign on the dotted line
If you've decided that renting-to-own is for you, or if you've fallen in love with a rental that has a purchase option, then your very next step should be to call your attorney. As stated before, different states and regions have their own laws pertaining to rent-to-own, so make sure your attorney is knowledgeable about where you're looking to sign a lease.
Monticelli tends to advise her clients to stay away from rent-to-own leases, but if her clients decide to go this route, she always recommends that they have an attorney review the contract and rewrite it to be more favorable to the tenant and mitigate risk. For example, tenants can make sure they're not paying double for the upgrades and renovations they're investing in and that the purchase price can't be hiked up when it comes time to buy. "If the seller won't renegotiate, take that as a warning sign," she says.
Once you get the all clear from your attorney, then talk to a lender:
"Ask to be prequalified and show the contract to the loan officer," Lewis says. A loan officer will take your financial information and let you know if you're on track to get a mortgage in a few years. They'll also make sure your portioned rental payments will add up to make a down payment when that time comes.
And, of course, if rent-to-own seems too risky but you like the convenience of having your down payment savings bundled with your rent, there's always the option of moving to a cheaper place but paying the same amount in rent (that is, the cheaper rent to your landlord, and the leftover portion into your savings account).