Related: Rent to Own Homes: A Win-Win Real Estate Investment Strategy
How does rent to own work: The definition
Rent to own homes are also known as a lease option or lease to own agreement. This real estate investment strategy allows potential buyers to purchase an investment property later based on a signed agreement between the buyer and the seller.
Generally, the answer to how does rent to own work is: it is a signed contract made between the property owner and the tenant saying that the buyer is allowed to keep renting out the property for a certain amount of time before actually purchasing the property. The buyer claims ownership after the contract finishes and the property is paid for. The seller is not allowed to place the investment property for sale or put it back on the market unless the contract is broken by either party.
Rent to own is favored more by buyers than sellers for many reasons. Potential buyers who are not able to purchase an investment property with cash or get qualified for a mortgage loan due to a bad credit score are the ones asking “how does rent to work.” Rent to own homes give buyers more time to save up money to purchase the property without having to worry about paying a down payment.
Read Also: Buying an Investment Property: Cash or Mortgage?
Some rent to own agreements give tenants the option to (not obligation) to purchase the property when the contract finishes. However, this is only the case if the word “option” is in the contract. Some contracts say lease-purchase without the word option and the tenant could be legally forced to purchase the property when the contract expires. So make sure to double check all the details in the contract before signing.
How does rent to own work: The process
While rent to own may sound like a dream come true for many home buyers, the process is not as easy as it seems. There are a lot of things to take into consideration and many aspects involved in the process that you must follow. Here are some important aspects related to the process of rent to own.
1. How does rent to own work: Option money
Unlike the 20% down payment that is typically paid upon the purchase of any investment property, rent to own homes have a smaller down payment. In the rent to own agreement, the renter has to pay a range between 2.5-7% of the property’s purchase price. This is known as option money or lease option fee and is usually non-refundable. This fee allows the renter to purchase the property in the future after the lease agreement expires.
The option money paid by the renter is considered as part of the purchase price when closing the real estate investing transaction. However, this may vary from contract to contract so double check all the details involved in your agreement the property owner. So for example, if the property’s purchase price is $200,000 and in the contract, there is a 5% lease option fee, then the tenant has to pay $10,000 up front. This is a lot less than what you would have to pay for an investment property with a typical 20% down payment!
2. How does rent to own work: Purchase price
The purchase price of the property is determined between the seller and the buyer. Some may agree on the property’s purchase price when signing the contract while others agree to determine the price after the lease expires and base the property’s price on the fair market value. It is highly recommended to agree on the property’s purchase price before signing the contract since real estate markets are unpredictable. The value of the property may increase in the future, therefore, increasing the property’s overall purchase price.
Related: Top 10 Real Estate Markets for Buying Rental Property in 2018
3. How does rent to own work: Rent
When people first hear of rent to own, they automatically think that it is a way to pay rent for a certain amount of time until you are able to purchase the property. However, the rent that is paid by the tenant is not all applied to the property’s overall purchase price. In a rent to own agreement, only a certain amount of the monthly rent is applied to the purchase price- this is known as rent credit.
So let’s say that your agreement was to pay $1,200 monthly rent and 25% of that is the rent credit. This means that if the time period of the lease was three years, then you will earn $10,800 rent credit to apply to the property’s overall purchase price.
This is why you will notice that many rent to own homes have slightly larger rent payments than regular rental properties. The rent payments are a way for the property owner to make up for taking his/her property off the market and renting it out to the buyer.
4. How does rent to own work: Maintenance
In some lease to own agreements, the tenant may be in charge of maintaining the property in terms of repairs, taxes, and insurance. Some sellers may choose to take care of the property’s taxes and insurance since the property is technically theirs. However, before signing the lease contract, always make sure to check the maintenance requirements. Fixing up a broken pipe or damaged rooftop is much different than taking care of the lawn or a new paint job. You don’t want to get yourself into an investment property that requires you to put more money from your pockets in maintenance.
5. How does rent to own work: Purchasing the Property
Like I said before, the tenant can but is not forced to purchase the property at the end of the lease. That is depending on the agreed terms in the contract. If the buyer does not want to purchase the property or cannot secure financing for some reason at the end of the lease, then the option expires. The buyer, however, will lose the option money and rent credit. If in the agreement the buyer was obliged to purchase at the end of the time duration written in the contract, then the property owner may take legal actions.
On the contrary, if the tenant wants to purchase the investment property, then he/she would have to apply for a mortgage loan and pay the property owner in full, taking into consideration how much of the rent credit was deducted from the property’s price. When the transaction is finished, the buyer claims ownership of the property.
How does rent to own work: Pros and cons
The pros of rent to own homes
- Equity growth
Rent to own homes help renters save up money to pay towards the down payment. This is done through a portion of the monthly rent which is applied to the property’s purchase price.
- Very low Competition
Since the property is not placed on the market, there is no competition. No one can compete for the property which is a good thing for the buyer since the price can’t go up if there is no competition.
- Control of the Property
The tenant has the power to make any improvements the property may need while paying monthly rent. This gives the buyer the opportunity to control the property and make repairs before owning the property.
Read Also: Rent to Own Homes: The Many Advantages and Few Disadvantages
The cons of rent to own homes
- Nonrefundable down payment
The option money that the buyer is required to pay is nonrefundable. So if you choose to not purchase the property at the end of the lease agreement, then you will lose your down payment. Moreover, if you decide to renew your lease, then you are expected to come up with another down payment.
- Delayed payments are not accepted
You have to pay the rent on time otherwise you might lose your right to purchase the property. There are consequences of late payments that can drastically affect the property’s purchase price. Some agreements state that late payments do not count.
The bottom line
There are many ways to buy investment property even if you don’t have the financing to do so. Rent to own is one alternative. However, it is not an easy process and requires attention to detail and knowledge of real estate investing. If you want to learn more about how does rent to own work or other ways to buy investment property, visit Mashvisor’s knowledge center!
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