On the road that leads to homeownership, there are a lot of steps. However, just as the old proverb says, “A journey of a thousand miles begins with a single step”. In this series of articles, we will walk you through several of the crucial steps that many homeowners before you have taken. Along the way, we will give you some tips and advice on how to navigate this journey so that, someday, you will step over the threshold of your very own home.
Step 5: Is Rent-to-Own Better Than a Mortgage?
For many people in the United States, owning your own home is a bucket list item. But it may not be on everybody’s list. And for some, if their financial situation will not support such an immense investment, it could simply not be the right time. However, if you are interested in owning a home and are tired of spending your money on rent that isn’t building equity, then there is another option.
A rent-to-own home is where you sign a lease on a property for a set period of time with the intent to purchase that property once the lease has expired. The current homeowner and you settle the lease terms and, typically, a portion of your monthly rent payments are credited toward the home’s sale price. Once the time period of the lease has elapsed, you have the option to either renew or buy the place.
But can a rent-to-own lease be better than signing a traditional mortgage? Let’s take a closer look.
A Tale of Two Leases
The first thing to understand about rent-to-own properties is that the contracts fall into two different categories – lease-purchase and lease-option. Both of these contract types cover a rental period of anywhere from 1 to 3 years with the ability to purchase the home once the lease expires.
- Lease-Option. This type of lease gives you the right to purchase the home once the contract has ended, but removes the legal obligation to do so. With this agreement, you can choose to not purchase the home without any penalty, however, you would forfeit the option fee you paid upfront (which is typically close to 2-7% of the home’s total cost). These also generally come with a higher monthly rent, which would also be forfeited if you decide to not buy the home.
- Lease Purchase. This type of lease is a legally binding agreement that you will be buying the property once the stated time period has elapsed. A price for the home is locked in at the time that the contract is signed, so you know exactly how large of a loan you need to acquire before that date arrives. With this contract, a larger portion of your rent is applied toward the eventual sale of the home. It is worth noting, however, if you change your mind about purchasing the house (or if you cannot qualify for the loan), legal consequences can be brought against you.
Now that we have covered how rent-to-own leases differ from traditional mortgage contracts, we can dive a little deeper into why the former might be a better option than the latter. Obviously, these points all depend entirely on your particular financial situation and the details outlined in the lease you are looking to sign. Do yourself a favor by being thorough in your research and, as always, read your contract carefully.
Think of It As a Test Drive
With the lease-option contract that we just discussed, this arrangement could give you the chance to see what you are getting into before you make the commitment to any given home. You have the opportunity to really get to know the neighborhood and the property itself, and all of the ups and downs that come with living there. It will give you plenty of time to determine if this is the right long-term home for your needs, or possibly even if homeownership is even the right decision for you at all.
Likewise, if you have just started a new job or are uncertain if your finances are stable enough for a traditional mortgage, this could provide the necessary flexibility you need.
Again, this perk isn’t applicable if you sign a lease-purchase agreement.
Bringing Down the House… Price
Having enough money to bring to the down payment is difficult for many people, especially given the current economic state in which the country finds itself. Qualifying for a mortgage loan comes with a lot of up-front costs. On the other hand, signing a rent-to-own lease means that you typically only need to pay a security deposit of one month’s rent (plus the option fee, if you sign a lease-option contract). So long as you don’t damage the property, your security deposit should be returned to you.
Time to Get Things in Order
Maybe you are willing to take on a mortgage but your finances or your credit are preventing you from doing so. A rent-to-own contract could give you the time you need to get those things into better shape. You could repair your credit and help to lower the interest rate by the time you sign that mortgage.
Just know that rent-to-own monthly payments aren’t usually reported to the credit bureaus, so renting is not likely to affect your credit score. You can request for your landlord to report these payments, however.
Lack of Maintenance & Repair Costs – Maybe
While it should be noted that this is not typical of these kinds of leases, some landlords may be willing to negotiate who pays for the repairs needed until a certain date. Naturally, this would translate into big savings for you in the meantime. But you also need to keep in mind that this could very well be your home someday, so it might behoove you to be the one who chooses how things are repaired and what kinds of replacements are installed into the property. After all, some of these things could have an impact for years or even decades.
Avoid Paying Property Taxes
Property taxes can take a big bite out of your wallet each year, especially depending on where you live and what the appraised value of the home is. In some places, this can be several thousand dollars annually. But until you officially become the new owner of the home, you won’t be the one who has to pay this money.
Much Lower Cost of Insurance
Carrying a renters’ insurance policy is much cheaper than the cost of homeowners’ insurance. You may not even be required to have renters’ insurance at all, but that isn’t a decision that you should make lightly. Renters’ insurance covers the things your possessions within the home against damage, theft, or vandalism. The policy that your landlord carries will not protect your belongings.
Building Equity Directly Into Your Home
One of the best things about a rent-to-own lease is having a part of your monthly rent payments go straight into the equity of what will likely become your future home. Perhaps the biggest drawback to renting is that the money you pay each month isn’t going towards any form of investment or contribution to your equity. The specific lease agreement you sign will usually outline exactly how much of your rent is going to be applied toward the home’s purchase. Make sure that this percentage is plainly spelled out in writing before you sign. The money you pay this way will make it easier to qualify for a lower interest rate when you do take on that future mortgage loan.
The Price is Set
In a standard rent-to-own lease, the price of the home is locked in at the time it is signed. That means that when the lease expires, that is what the home is going to sell for. You should check your particular contract before signing, as this is not always the case. But this can be particularly advantageous in markets where the price of housing has been increasing steadily over time.
Planting Your Flag
One of the benefits of a rent-to-own lease is that, once it is signed, the home cannot be sold out from beneath you. If you find a place that you fall in love with and you want it off the market, this is a great way to do it. It gives you the time you might need to be able to afford to purchase the home while also getting the opportunity to move immediately into it. Some sellers may not be willing to enter into a rent-to-own situation, but you will never know if you don’t ask.
- Find a Lease That Works for You. Weigh the pros and cons of both lease-purchase and lease-option contracts to see which is the best fit for your needs. You need to be certain that you are going to be capable and willing to buy the home before you put your name on a lease-purchase agreement.
- Hire Professionals. Get a trustworthy real estate agent and, while you are at it, consider hiring a real estate lawyer as well. Have them go through any contract you are considering and make certain that terms are outlined clearly. There needs to be no question as to things like when the rent is due, if any appliances will be included with the sale, who performs maintenance, and what percentage of the rent is applied to the cost of the home.
- Know Your Contract. Read the contract thoroughly, including the fine print. Then read it again. You need to thoroughly understand the obligations and deadlines that you will be expected to honor. Know what the cost of the home will be and how you will be able to exercise your intent to purchase it when that time comes. Figure out how much the rent payments (and the option fee, if applicable) are going to cost you. Understand if there is a pet policy or other fees that you may need to pay as well.
- Check Out the Home. You should know what you can about the home before you enter into an agreement. Research what information you can about it and its history – whether it has been through any natural disasters, such as floods or fires for example. You should also hire a professional home inspection on the property, as this could identify any possible issues that need to be addressed now or in the immediate future.
- Research the Homeowner. While it may not be as easy as finding information about the property itself, it can be a good idea to look into your future landlord. Obviously, you should stick to public records when doing this. But it might be worth a quick internet search just to give you a better idea about who you might be signing a contract with.