Rent-to-own seems like a straightforward concept: a tenant rents with the intention of one day owning the property. While seemingly simple, this strategy is not often used. Rent-to-own is an alternative to traditional property financing and is only ideal in certain situations.
Table of Contents - What Are Rent-to-Own Properties, and What Are the Benefits?
If the tenant knows the neighbourhood and the house he or she wants but isn’t quite able to make a purchase yet, rent-to-own could be an attractive option. Rent-to-own can also help sellers who are struggling to sell the home but have an interested buyer who cannot fully afford to purchase the house just yet. With rent-to-own, everyone has an opportunity to get what they want from the real estate market.
How rent-to-own works
Before entering into the rent-to-own situation, the tenant and landlord sign a lease agreement detailing the terms. The agreement outlines the tenant’s monthly payment, which includes rent plus an additional amount that builds towards the down payment on the home. It also states the purchase price of the home, which cannot be altered while the agreement is in effect. The tenant has the option to buy within a certain period – usually three years.
If a tenant’s monthly payment is $1,600, it might be that rent is $1,250 and the remaining $350 is applied towards the down payment. This $350 is also called the “option fee.” At the end of a three-year term, the tenant will have $12,600 put towards the down payment. If the house has a purchase price of $250,000, that’s more than the minimum 5 percent required for a down payment. The tenant is now the buyer of the home he or she has enjoyed for the past few years, and the seller has sold the home at a locked-in price while profiting from the investment.
How rent-to-own benefits the seller
Rent-to-own is an appealing option for sellers who are struggling to move on from a property. The problem may be that it is more common to rent in the neighbourhood, or buyers in the area don’t have enough credit to afford the price you’d like to get for your property. Whatever the case, you can earn passive income on a property and increase your likelihood of finding a buyer by using rent-to-own.
One of the key reasons why sellers enjoy the rent-to-own option is that it secures the purchase price on the property. The longer you leave the property on the market, the more likely it is to depreciate. Rent-to-own can calm your fears if you’re worried about market fluctuations. You may fetch a better price than you would on the open market if you’re willing to wait.
There are some risks with rent-to-own. The tenant always has the option not to buy the property, or the tenant may still be able to secure financing by the end of the agreement. You may lose out on the price you had hoped to get. That won’t exactly put you back at square one though: you’ll still have collected rental income during that time. Since the tenant had planned on buying the property, the tenant likely took much better care of the space than any other renter you could have found.
Because the purpose of rent-to-own is securing a buyer for your property, you’ll need to do your due diligence. Make sure your potential tenant/buyer has high enough credit that qualifying for a loan shouldn’t be an issue in three years. Ideally, the tenant will have pre-approval for a mortgage at the purchase price. In that case, the tenant will use the rental period to build credit for a better interest rate.
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If you’re interested in using the rent-to-own model for your property, you’ll need to create the right agreement that protects you and the tenant. There is no standard for creating rent-to-own agreements, but a real estate lawyer can help. If possible, the tenant should also consult a lawyer. The agreement will include the purchase price, monthly payments, option fee and lease term. Additionally, it will outline who is holding the down payment and how any state or local taxes are handled.
If you think you’ll want to sell your property more quickly than the tenant will be able to purchase the home, rent-to-own may not be right for you. Talk to your lawyer about including terms in the lease that allow you to sell the home more quickly if necessary.
Why tenants/buyers like rent-to-own
One of the main reasons why tenants enter rent-to-own situations is because their credit is not great. Rent-to-own allows tenants to live in the home that they want to buy and build their credit while financially investing in the home. While renting, tenants can improve their credit score so that when they’re ready to buy the house, their monthly mortgage payments and interest rate are better.
Rent-to-own is ideal for tenants who have no plans to move anytime soon. Rather than renting in a cheaper space and waiting until the dream home becomes a reality, a tenant can handle all housing plans at once. The seller, the realtor and possibly the lender are already part of the process, so the transition is smooth. The best part? No moving. If the tenant does decide to move, those monthly option fee payments are lost. Rent-to-own tenants should be committed to the home for the foreseeable future.
Just as sellers want to secure pricing to prevent lost value, buyers take the same gamble. With their rent-to-own agreement they secure a price on the home they should be able to afford (based on the mortgage pre-approval paperwork they should have received before signing the agreement). However, market fluctuations may mean the house is worthless at the end of the lease period.
Rent-to-own could be your entry point into real estate investing, even if you weren’t planning on becoming a landlord or seeking passive income. If you have a home that just won’t sell, consider rent-to-own as your solution for securing a great tenant and a great buyer, all for a great price.
How to Do Rent to Own Real Estate
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