Rent-to-Own - What’s that all about?

First-time buyer - I saw a listing that said "rent to own option", what's that all about?

Answer - One way to get into home buying without having the necessary down payment or a good enough credit score right now is to find a seller willing to rent the place to you (normally a lease for some specific time period) who will agree to set aside and accumulate a small portion of your rent payment towards the down payment. That will allow you time to repair your credit and get the down payment together.

This is often called “rent-to-own” or “lease with an option”. It is somewhat similar to a “Land Contract” in that the owner retains title to the property, but the contract to buy the property is in the future, normally at the end of a two-three year rent/lease period. At that time, if you decide not to exercise your option to buy the property, all of the monies that have been collected and set aside by the owner usually revert to him/her, just as if they were always a part of the normal rent payments.

Should you decide to go ahead with the purchase, the monies that have been set aside are contributed by the owner at closing, just as if you had been putting that money in a bank all along (albeit a bank that was paying you no interest for that time). Depending upon the agreement that you negotiated up front, that could amount to hundreds or even thousands of dollars towards the purchase price of the house.

Some rent-to-own deals require that the purchase agreement be signed at the time that the rental agreement is signed. Those agreements lock in the price for the buyer, which is a good thing for them if prices are on the rise. That Purchase Agreement is then put away until the anniversary date and either executed as a sale or rendered invalid by the renters decision not to proceed. If nothing else, the rent-to-own purchase agreement usually gives the renter the first right of refusal on the house upon the anniversary date.  Every rent-to-own contract is a custom agreement between the owner(s) and the renter(s). You should seek good real estate advice and perhaps even legal advice before signing any agreement.

From the Sellers’ perspective this is a lease with a better than average chance for a sale at the end. The seller

may look at this deal as one that discounts the sale price by the amount that has been set aside during the lease period (and perhaps any appreciation that takes place over the period of the rental). After all that was the Seller’s money (a part of the lease payments) that he is now taking off the sale price. Some sellers actually set that amount of money aside out of the lease payment each month and some just wait to see what the buyer is going to do and then discount the price by that amount at the time of the sale. In either case, the buyer never really gets that money back from the seller.

The buyer should also check with his/her Mortgage Company about how they will treat this “down payment money.” Many will just see it as a Seller Concession on the price and still require the buyers to come up with down payment money of their own, albeit on a lower purchase price. Underwriters have different views of things.

Risks involved

There are risks involved for both parties in a rent-to-own scenario. Obviously the Seller is taking the property off the active market and letting a renter in, so the risks are the same for him as it would be in any rental scenario – what if the renter trashes the place or what if they get in and stop paying? Sellers should do the same level of due-diligence vetting of renter in the rent-to-own case as they would for a regular lease. 

For the buyer the risks revolve around the money that is supposedly being accumulated by the owner and the owners’ behavior. Should the renter decide that they really don’t want to buy the place after all, it will be next to impossible to get any of the money back that was supposedly being held for the purchase. Most rent-to-own contracts will contain wording that states that the money was just part of the normal rent, if the purchase is not made.

The other risk for the buyer/renter is that you've moved in and been faithfully paying the rent only to come

home one day and find a Foreclosure Notice posted on the front door. That happened a lot during the recent downturn. The owner moved on to a new home and probably used your  rent payments to make his payments on that house and just let the one that you've living in go into foreclosure. What recourse do you have? Very little it turns out.

You can, of course, try to sue the owner to get your rent payments or at least your down payment money back, but that is difficult. Maybe you can get him charged with fraud, but that may not get your money back either. You are stuck between a rock and hard place. Your “down payment money” is gone and you’ll soon have no place to live. Don’t expect any sympathy from the bank that is foreclosing on the place. Your plight is not even on their radar. This is just an SOL case of a risk that you took that didn't work out.

To protect yourself as much as you can, be sure to vet the owner as much as he vets you. Ask to see payment statements from his mortgage company at least quarterly during the rental period and try to write a provision in the lease agreement that at least says that he will return your down payment money if he allows the house to be foreclosed (although actually getting it will still be an issue if he is in that bad of financial shape). The best scenario up front is to have the owner set up a separate escrow account for the money that’s being accumulated. The owner will still usually be in control of that account and may drain it, but you’ll have a better case to work with in the courts as you try to recover it.

So, is this a good way to try to get into home ownership? The best answer is – maybe. If you find a good, honest owner/landlord who is going to keep up his payments on the mortgage and is going to actually set aside the funds that you think are there for your down payment later; then it is a good way for you to buy the time needed to repair damaged credit and/or put aside enough for a down payment. Like any other real estate transaction, it is up to you to do what you can to protect yourself from the risks.