Consider a Rent-to-Own Option to Buy a Home
A rent-to-own contract, also called a lease-to-own contract, allows a buyer to rent a home with a portion of each month’s rental payment applying to the down payment. At the end of a certain period of time, the buyer has the option to either walk away from the home or buy it at a pre-determined price. Lawyers call these option contracts.
Rent-to-own contracts can be a great deal for buyers and sellers under certain circumstances:
- Local real estate market is soft with too many houses for sale, and
- Buyer cannot qualify currently for a traditional mortgage, and
- Buyer can improve their creditworthiness to qualify in a year or two.
Rent-to-own contracts are not a cure-all for potential homeowners who will lack the ability to qualify for a mortgage at the end of the lease period, or sellers who want to unload unwanted homes. Unfortunately, unscrupulous people are marketing rent-to-own deals to both buyers and sellers as a risk-free answer to weak creditworthiness and markets with many homes for sale. The table below outlines the major pros and cons of rent-to-own home deals.
|Pros & Cons of Rent-to-Own Home Deals|
|Buyer evaluates neighborhood & property without commitment||Seller has long-term commitment with buyer|
|Seller gets a tenant with interest in treating property well||Contract must specify exactly who is responsible for maintenance items|
|Seller receives rental income||Cash-flow may not be positive|
|Broad market of potential buyers||Must weed-out unqualified buyers|
|Seller pays no or low real estate agent commissions||May be penny-wise, pound-foolish if a traditional sale better meets seller's needs.|
|Buyer & seller know the eventual purchase price||If purchase price is fixed, one party may be disappointed if market moves in unexpected direction|
|Rent-to-Own Contract Items|
| • Brief description of the property |
• Amount of initial payment
• Amount of monthly payments & when due
• Other payments, if any
• Party liable for loss or damage in excess of normal wear & tear
• Delinquency charges & reinstatement fees
• Party responsible for maintenance or service
• Contract termination terms for both parties
• Payments & other fees necessary for acquisition
• Formula or method the purchase price will be determined
• Price of any personal property included
• Agreement to transfer any manufacturer warranties
• Party responsible for property insurance
• Buyer equity earned during rental phase
Rent-to-own home purchases are not like rent-to-own furniture deals where the buyer “rents” the item until the final payment is made. In a rent-to-own home purchase, the seller may apply a portion of the monthly payments to a downpayment. The “rent” part of the rent-to-own deal will last for a period of time the buyer and seller negotiate. There is no set standard for this period of time. At the end of that period, the buyer has the option to purchase the property for a price agreed to in advance — typically. If the buyer decides to buy, which is called "exercising the option" in the legal business, the buyer needs to qualify for a home loan.
If you are contemplating a rent-to-own home purchase, then it is probably because you cannot qualify for a traditional mortgage. This may be due to your credit score, your lack of a downpayment, or both. A FICO credit score of 580 is the minimum the FHA accepts, however lenders who make FHA loans can require a higher credit score. According to the FHA, more than 90% of all FHA loans approved are for applicants with credit scores of 680 and above. The National Mortgage News reported in 2012 that the average credit score for an FHA loan was 700. If your credit score is less than 580 when you enter into a rent-to-own deal, you will need to work on boosting your credit score.
Your credit score may not be your only impediment to qualifying for a home loan. Lenders look at the amount of debt a potential borrower has in comparison to his or her income. This is called the “debt-to-income ratio” (DTI) in the mortgage business.
The FHA looks at your DTI two ways.
The first is to compare your gross income to the new principal and interest mortgage payment, an escrowed portion to cover the property taxes, homeowner’s insurance, the mortgage insurance premium, etc. To qualify for a loan, the percentage of these costs may not exceed 29% of your gross income.
The second ratio compares your gross income to the costs listed above plus your other monthly payments, such as a car payment, a student loan payment, and the monthly minimum payments required by credit card accounts. To qualify for an FHA loan, these costs may not exceed 41% of the gross income.
If your existing debt load pushes you above the FHA minimums, then consult with the Bills.com Debt Coach to learn your options for resolving your debt.
Moving Ahead With a Rent-to-Own Deal
Whether you are a buyer or seller, beware any rent-to-own a home deal that seems to good to be true. If you are a buyer, make sure you understand the minimum credit score you need to qualify for a loan, and that you have an acceptable DTI ratio. Also, study the three tables on this page that outline the issues buyers and sellers need to resolve before signing a rent-to-own deal.
Sellers need to understand all of these issues also so that they are not surprised when the buyer exercises the option to buy the property. Both buyer and seller should consult with a lawyer who has experience in real property or contracts law before entering into a rent-to-own deal.
|What a Buyer & Seller Should Consider in a Rent-to-Own Deal|
| • Do you qualify for a mortgage now? |
• Will you qualify for a mortgage at the time of purchase?
• Are all contract terms clear?
• What are the exit options & costs?
• What are your credit score issues, & how can you fix them?
• What, if any, claims are on the title?
• Do you have reserves to pay for taxes & maintenance?
| • Buyer's income, job security, credit history |
• A "Plan B" if buyer defaults or decides not to buy
• Tax implications of this deal, if any