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How Rent-to-Own Lease Agreements Benefit Both Tenants and Landlords

Sooner or later, most renters realize that they are throwing money away with each rent payment. Yes, they have a roof over their head and, of course, the landlord is responsible for the property's maintenance, but as tenants they are not building equity or getting the tax advantages that come with home ownership.

For a lot of people, imperfect credit and living paycheck to paycheck stand in the way of making such an important purchase. A rent-to-own lease agreement is one way that tenants can get around the credit trap and start building equity. It can also be a good solution for landlords who wants to sell but find themselves stuck in a buyer's market or with property in an undesirable location.

What follows is an explanation of the primary advantages of rent-to-own lease agreements—for both tenants and landlords—as well as some practical advice for renters who are considering this option.

Rent-to-Own Lease Agreements: The Basics

Buying a home through traditional channels is the same whether you use a real estate agent or negotiate directly with the home owner. After the owner accepts your offer, your broker negotiates with lenders to find the best financing available to you based on your credit score, the amount of money you are able to use as a down payment, and other factors.

Once you sign the necessary paperwork, you become the official property owner, the title transfers to your name, and you are now responsible for both maintenance and the payment of property tax.

Likewise, renting a home usually follows the same basic format. You sign a lease agreement stipulating that you will pay your landlord a certain amount of money each month and abide by certain conditions set forth in this document, and the landlord generally pays for maintenance and holds a security deposit against any damages you cause while living in the property.

Rent-to-own lease agreements are a hybrid arrangement combining some aspects of new home purchase with a traditional lease agreement. Here are the main features of the agreement:

  • Tenants pay an upfront fee and/or larger monthly rental payments in order to have an option to purchase – The rent-to-own option begins with a commitment from the tenant in the form of higher payments or an initial fee, or both. The landlord either deposits the extra money in an escrow account, awaiting the time when the tenant exercises the option to purchase, or the landlord takes a percentage of the extra money each month and applies it to the principal owed on the property. The second option allows a tenant to build equity in the home before they officially own it. In the case of the first option, the landlord refunds the escrow monies to the tenant at the time of purchase. In the eventuality that the tenant does not exercise the option to purchase, or they do not meet the terms of the lease agreement, they forfeit both the initial fee and any additional rent they paid.
  • Tenants and landlords sign a lease agreement – Rent-to-own lease agreements start off looking a lot like standard leases because the eventual transfer of the property from landlord to tenant is contingent on two things: (1) the tenant's successful fulfillment of the lease agreement, and (2) the tenant exercising the option to purchase. Until that time, the home belongs to the landlord.
  • The tenant must fulfill the terms of the lease agreement – If the lease prohibits pets or subletting to unauthorized guests, the tenant must comply with these regulations just the same way they would if this was a regular lease. Should the tenant fail to fulfill the terms of the lease agreement, they forfeit the extra money they have invested in the rent-to-own option.
  • The tenant is responsible for maintenance – A big difference between rent-to-own lease agreements and a standard lease is who takes care of the maintenance. When you are renting to own a property, the presumption is that it will belong to you at some point. Thus, you are responsible for fixing problems as they arise.
  • The title remains with the owner until the tenant exercises an option to purchase – In a typical home purchase, buyers get the title to the property as soon as they exchange money at closing. That is not the case in a rent-to-own lease agreement. Tenants do not own the house until they exercise the option to purchase. Moreover, they could jeopardize that option at any time for failure to fulfill the terms of the lease agreement.

Advantages to Landlords

There are a number of obvious benefits for landlords using rent-to-own lease options:

  • The landlord avoids having to pay the agent commission associated with selling a home. Since these fees typically run six per cent of the home's selling price, that is a sizable saving.
  • The landlord assumes very little risk in rent-to-own lease agreements. The regular terms of the lease must be fulfilled, so there is no increased risk from damage. The tenants must take care of maintenance themselves. Should the tenants fail to pay rent on time or violate other items in the lease agreement, they forfeit all of the extra payments they have made to the landlord.
  • Rent-to-own lease agreements give landlords a way to liquidate properties in less than ideal market conditions. For instance, if the property is at the end of a busy commercial street, it would take much longer for that house to sell through conventional means. Other houses might need thousands of dollars invested in their curb appeal or basic infrastructure. In a rent-to-own lease situation, the tenant absorbs that responsibility, saving the landlord money, time, and aggravation.

Advantages to Tenants

Although more and more millennials are renting by choice, the fact remains that homeownership eludes millions of Americans because they lack the financial stability to purchase a home. For them, renting is not a deliberate strategy; it is a way of life, and an insecure one at that.

The primary advantage of entering a rent-to-own lease agreement is that it offers people a way to build credit and become a homeowner. In some cases, tenants are actually able to build equity in the home while they are still renting. Theoretically, making extra payments in rent gives tenants a greater stake in the property and can therefore encourage creditworthiness in the form of regular and timely rent payments.

At the same time, should a tenant's financial situation worsen, they are not obligated to exercise the option to purchase. They will forfeit any extra money they gave the landlord, but they do not have to face the potentially much more severe ordeal of going through a foreclosure.

What You Need to Know to Avoid Problems

For Landlords

There are a couple of risks that landlords take when they enter a rent-to-own lease agreement. First, tenants may not undertake to perform maintenance in a timely or effective manner. If the tenant then chooses to forfeit their option to purchase the property, the landlord might be stuck with a property that needs substantial renovation before it is presentable to new tenants or can be made ready to sell.

The second risk lies in the nature of the contract itself. The landlord is obligated to sell the house to the tenant, but the tenant is not obligated to buy the house. They can forfeit the agreement, leaving a property that could be hard to sell or rent in the landlord's hands.

Landlords can attempt to avoid these problems by maintaining a close relationship with the tenant and working with the tenant on small lapses in payment. Ultimately, though, the landlord has no control over the tenant's financial situation.

For Tenants

Tenants, on the other hand, could be stuck between a rock and a hard place if they enter a rent-to-own lease agreement. Most tenants find themselves in this position because they don't have many options to purchase property. Furthermore, if they end up forfeiting a rent-to-own lease agreement, they could be out of thousands of dollars—with nothing to show for it.

One important remedy for tenants is to inspect the house and get an appraisal. Since the rent-to-own lease agreement contains the future agreed-upon price of the home, this is the most important way for tenants to avoid paying above market value.

Moreover, since they will be financially responsible for maintenance, having an inspection gives the tenants a good sense of what major repairs the home needs and when the repairs need to be completed. For instance, if the HVAC unit has one more summer before it needs to be replaced, a cash-strapped tenant may find themselves unable to afford the repair.

In circumstances like these, it makes little sense to enter the rent-to-own lease agreement. You should only do so if you can afford not just the monthly rent payments but also the cost of both necessary repairs and regularly scheduled maintenance. Some experts recommend budgeting one per cent of a home's value a year to maintenance expenses. While there are some things you can scrimp on—that new carpeting can wait—you will run into occasions when you have to spend money right away to fix a problem. You need to be prepared.

Some Final Advice for Prospective Homeowners

Homeownership is a long game with many financial and psychological rewards. For most Americans, it is the primary means of building wealth, and this wealth can be leveraged in a number of ways, making it possible to send your children to college, to consolidate outstanding debt, and to provide you with a secure retirement.

People who choose rent-to-own lease agreements must keep their eyes firmly on that prize, recognizing that they are buying creditworthiness and have to pay a premium for that privilege. Even if the house you are renting to own is not your dream home, it can put you on the property ladder and bring you much closer to purchasing the home of your dreams.

Tenants interested in pursuing this option should think strategically about the long-term benefits for themselves and their families. Some questions you need to ask yourself are:

  • Can I afford to make necessary repairs to this property before I am able to exercise the purchase option?
  • Is the extra rent payment something I can afford?
  • Am I either committed to living in this home or to transforming this home into a property that I can sell in a few years?
  • Is this home in a location that makes resale difficult? Can I make improvements that will boost its salability?

Even houses in poor condition or less than optimal locations can make good investments. For instance, you can cash out the equity in such a home to afford the down payment on a house that better meets your needs, and then continue to rent out the first home to someone else.

Whatever you decide, your plans must include developing solid financial habits. If you can make the commitment and swing the extra expense, though, a rent-to-own lease agreement is a solid opportunity to stop paying rent and start building equity.

How to Create a Rent-to-Own Lease Agreement

Use our customizable rent-to-own lease agreement template to create, download, and print your agreement right now.