Related: Financing a Rental Property: How to Buy a House with No Money Down
Rent to own and owner financing are two unconventional but lucrative ways to purchase your next property. When it comes to home financing, it is easy to confuse a rent to own transaction with owner financing. Both transactions offer solutions for people with bad credit who are unable to get a conventional mortgage. Although they are similar in some ways, there are key differences between the two strategies. Rent to own provides buyers with the option of test-driving the property before buying it. Owner financing, on the other hand, allows them to outright purchase the investment property (without going through a bank).
Before we dive any further into the differences, let’s first define what exactly rent to own and owner financing are.
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What Is Rent to Own?
How does rent to own work? With rent to own real estate, the buyer or renter has the option of buying the home at some point in time in the future. Until then, the landlord is the real owner of the home and is responsible for mortgage payments on the property. Moreover, the owner’s name is on the deed. The buyer, on the other hand, can purchase the property but does not have the obligation to do so. In addition, the deal can potentially fall through without the buyer ever owning the property in the first place.
With rent to own homes, the purchase is classified as a lease-purchase. Typically, the rent to home contract includes a clause that specifies the following terms:
- The current sale price of the property
- The amount of rent that goes toward the sale price each month
- The amount of time it can be rented before it is bought. This gives the tenant more time to secure conventional financing to purchase the home.
Moreover, the majority of rent to own agreements require a hefty down payment. This payment is usually higher than a standard rental security deposit. For this reason, the monthly rent for a rent to own transaction is typically higher than a regular rental agreement in order to cover the amount applied to the down payment.
Related: Can’t Get a Mortgage? Try a Rent to Own Real Estate Investment
What Is Owner Financing?
So, now that we have defined rent to own, you may be wondering how does owner financing work? With this financing option, property ownership transfers from the owner to the buyer. In this case, the buyer becomes the new owner upon closing. In an owner financing contract, the owner acts like a bank by offering to finance the purchase.
Remember that in the case of a rent to own transaction, the buyer makes rent payments that may or may not apply to a purchase in the end. In contrast, with owner financing homes, the buyer pays off the loan after the purchase actually happens. This option is especially great for people who have bad credit or not enough credit to qualify for a conventional mortgage.
Like a rent to own option, owner financing typically requires a down payment that is usually lower than what mortgage companies require. The owner and buyer sign a mortgage agreement that includes the term of the loan, interest rate, monthly payments, and any additional clauses.
Related: Owner Financing: Is It the Best Way to Finance an Investment Property?
Advantages of Rent to Own and Owner Financing
As mentioned, the great thing about both methods of rental property financing is that they allow people with bad or no credit to buy properties without having to get a mortgage approval from a bank.
In a rent to own option, the buyer has time to save up for a down payment to the bank and to rebuild their credit before they seek financing. This option is ideal for those who want to learn about the neighborhood, schools, and the investment property itself before committing to a purchase.
In an owner financing situation, the buyer owns the rental property and has the freedom to customize it to fit their needs.
Disadvantages of Rent to Own and Owner Financing
Financing real estate investments isn’t without its downfalls. A rent to own transaction can be dangerous for the buyer for several reasons. If a buyer falls behind on their rent and is evicted, they lose their down payment. They also lose the payments they made on the sale price of the property. This scenario also happens if the buyer fails to qualify for mortgage financing before the end of the lease term. In this case, the seller may choose to not renegotiate the lease and force the buyer to move out. More times than not, the buyer is unable to recoup any of the money they already paid toward the home. In addition, if a buyer is renting to own, they are counting on the owner to pay for the mortgage on the real estate property. What if the owner fails to pay for the mortgage and the bank forecloses on the home? In this case, the buyer has to move out at the end of the lease. Moreover, the buyer most likely won’t get their down payment or any other rent payments back.
With owner financing, the owner can’t force the buyer to leave a house they’re financing unless they start foreclosure proceedings in the case that the buyer fails to make mortgage payments. In order for the owner to finance the home, they can’t owe money on it. This prevents the buyer from losing the house through a foreclosure on the owner. The buyer should ensure that there is no existing mortgage on the investment property by finalizing the owner-financed mortgage via a real estate expert such as an attorney.
Moreover, the buyer (legal owner) of the owner-financed home is responsible for maintenance and taxes. This differs from a rent to own situation, where the owner handles these items. Regardless, both rent to own and owner financing options require the buyer to pay more either through a higher sales price or higher interest rate.
In Summary
Although there are inherent differences between rent to own and seller financing, they are also similar in some ways. In both cases, the buyer is trying to build credit so they can qualify for a loan. The buyer does this by making payments to the seller until they get a loan from somewhere else. The main difference between the two is when the ownership transfers.
With either rent to own or owner financing, there are numerous risks associated with each transaction. This is not surprising considering that both the buyer and seller in these scenarios have an interest in the property at hand. However, they are still both great options for people with bad or little credit who don’t want to go through a bank.