Frequently Asked Questions and Answers About Rent to Own
What is Rent-to-Own, or a Lease Option purchase? Rent-to-own or Lease Option is a formal arrangement where someone rents a home for a certain period of time, and then has the option to purchase the home afer the rental period, all at a predetermined price.
How Does a Lease Option Work? First, a tenent-buyer and a seller decide on a home purchase price. Next, the parties set up an Option Agreement which outlines a fee the buyer pays the seller for the option to buy the home at a future date. The fee is usually 1% to 3% of the purchase price. Then, the tenant-buyer signs a Rental Agreement which outlines the terms of the rental or lease period. The Rental Agreement will spell out what portion of the monthly rent payments are applied, or credited, toward the future purchase price. These credits may be used toward the purchase down payment. The buyer moves in to the home, making monthly rent payments and accumulating Option Credits. At the end of the lease period, the renter obtains financing (through a mortgage or owner financing) to execute a Sales Contract to buy the home.
What is an Option Credit? An Option Credit is the portion of the total monthly rent paid that is applied to the final home purchase. For example, if a monthly rent payment is $900 and Option Credits accrue at $500 per month, then, over a 36 month lease, the renter will accumulate $18,000 in payment credit that can be deducted off the purchase price, or used toward a downpayment, if the renter opts to purchase the home.
What is an Option Fee? The Option Fee is a payment from the renter to the seller, before the renter moves in. This fee amount is negotiable, but is usually 1% to 3% of the final purchase price (that is, on a $100,000 home price, the Option Fee can be expected to be between $1,000 and $3,000). The Option Fee gives the renter the exclusive right to choose to purchase the home at the end of the lease period. The seller may not sell the home to another party during the Option period, and the renter may ultimately opt out, or not buy the home, however in that case the Option Fee is usually forfeited to the seller.
Who pays home insurance and real estate tax during a rent to own? The owner/seller is usually required to maintain full insurance and pay all property taxes and other fees, such as HOA (home owner association) dues as necessary.
What Agreements are needed for a Lease Option situation? There are three components to a rent to own. These are often spelled out in individual agreements, called the Rental Agreement (which outlines the terms for leasing and occupying the home, plus the rental rate and Option Credit accrued from the rent), the Option Agreement (which details the payment amount the renter must make to secure the option to buy the home after the lease ends), and a Sales Contract (to specify all terms of sale, including but not limited to the sales price, title, financing and seller or buyer obligations).
What types of buyers benefit from rent to own? The buyers find rent to own attractive include:
- People who have been turned down for a mortgage, but expect to qualify in the near future, and want to settle into a home.
- Buyers who expect to maintain and will work to improve their financial standing (FICO score, credit rating, save for downpayment) during a lease period with the goal of attaining an affordable home mortgage loan.
- Buyers with good credit and some savings available, but not enough for a full down payment on a home loan.
- People who are handy at repairs and maintenance who can build up and apply the dollar value of their skills toward a home purchase price.
Does the buyer have to buy the home at the end of the lease? Although lease option agreements may vary, the answer is usually no. The lease option should allow the buyer the option to leave the process after the lease is over.
What happens to the Option Fee and Credits if the buyer doesn't purchase the home? The Option Fee and any Credits earned or accumulated are typically non-refundable if the buyer does not purchase the home. The fee and credits act as incentives for the buyer to complete the purchase, and protect the buyer by maintaining exclusive access to the home purchase.
Why should I care about comparable rents? Buyers need to research comparable neighborhood rent rates to be sure the seller is not over charging. If the lease option rent is too high, it could signal the seller is trying to cover excess or additional loans taken out against the home. This could jeopardize the buyer's future ability to purchase the home. Comparing similar home rental rates also illustrates if the buyer's offer is reasonable or if it is too low and the seller is likely to reject it.
How can a buyer improve the odds for a successful lease option purchase? Rent to own buyers need to be committed to the purchase and to either rebuilding or maintaining good credit during the lease period. The purchase commitment is important because if the buyer walks away, the option fee and any option credits will not be refunded in most cases. Rebuilding or maintaining good credit is vital because the buyer will need to secure financing in time to make the final purchase at lease end. The buyer needs to set realistic financial expectations and have a concrete plan in place to meet their credit needs. Buyers with troubled credit histories may need professional help from a legitimate credit repair company. At a minimum, buyers should understand their credit scores and consider registering for a credit monitoring service.
How do I determine my monthly budget? Buyers need to calculate their Front Ratio and Back Ratio to see how much they can afford to pay monthly on a qualified mortgage. To calculate, take annual gross earnings (earnings before any taxes), divide by 12 and multiply that answer by (.28) for the Front Ratio and (.36) for the Back Ratio. The Front Ratio shows total affordable monthly housing expenses (mortgage loan principle, interest, taxes and insurance) and the Back Ratio shows the total affordable monthly debt payments (including housing expenses and other ongoing debts like car payments). For example, for a $60,000 gross annual income, the monthly amount is 60,000/12=$5,000. The Front Ratio is $5,000*.28 = $1,400 per month, and the Back Ratio is $5,000*.36 = $1,800 per month.