How does the rent-to-own process work?

Most of us rent until we can afford to buy a home. For many, when they pay rent, it can feel like a “waste” of money, because they don’t build equity with their monthly payments. As it happens, there is a way to make your rent help you meet your goal of buying a home. 

Let’s take a closer look at how the rent-to-own process works and how it can help you achieve your dream of transforming from a renter to a homeowner. 

How does rent-to-own work? 

The rent-to-own process (sometimes called lease-to-own) is an agreement that allows a renter to buy a home after years of renting. 

When you sign a rent-to-own contract, you pay more in monthly rent than the fair market value in order to save for the down payment. How much more you’ll pay each month compared to if you were just renting depends on how much you need to save by the end of the lease to buy the home. That sounds like a bad deal, but the reason you pay more is because those extra payments make up your down payment once the lease ends. 

If you choose not to buy the property once your lease ends, you lose the extra money you spent on those higher-than-usual rent payments. If you do decide to buy the home, you’ll still need to get a home loan and follow the typical process required to buy a home. The seller will give the money accrued to put towards your down payment to the lender.

When you’re in a rent-to-own agreement, you’ll split responsibility for repairs between yourself and the landlord. For example, while you may agree to tackle small repairs (like new light bulbs and paint touch ups), the landlord covers large repairs (like a leaky roof). This is one aspect that distinguishes rent-to-own from buying a house on contract, an arrangement where the buyer pays the seller for the house in installments.

Types of rent-to-own contracts

You’ll come across two main types of rent-to-own options for homeowners and renters: lease-option agreement and lease-purchase agreement. While both of these contracts allow the renter to lease a home for one to three years before they purchase it at the end of the lease, there are some important differences that you should be aware of. 

Lease-option agreement

With a lease-option agreement, the renter pays the property owner an option fee when they sign (about 2 to 7% of the home’s total value). This fee usually isn’t set in stone, so you should try to negotiate with the homeowner or their property management company to see if you can secure a lower fee than they originally offer. 

The additional rent payments (known as rent credits) you made are saved by the seller to go towards your down payment if you choose to purchase the home at the end of the lease agreement. Once your lease expires, you’ll negotiate with the seller to come to a fair purchase price for the home. You’ll need an appraisal to determine what the home is worth. Your option fee should help reduce the final sales price. 

You do have the option to walk away at the end of the lease and not buy the home, but you will forfeit your rent credits and option fee if you do this. 

Lease-purchase agreement

A lease-purchase agreement works similarly to a lease-option agreement. Under a lease-purchase agreement, you also lease the home for a few years and a percentage of your rent goes towards your down payment. The main difference between these two agreements is that with a lease-purchase agreement, you must buy the home once the lease ends.

Here, you’ll agree to a purchase price when you sign the lease. When you set a price for the home beforehand, you gain a better idea of how much you need to borrow from a mortgage lender. 

You’ll have plenty of time to shop for a home loan under a lease-purchase agreement, but if you don’t secure one by the time your lease ends, you give up your claim to both the home and any rent credits that accumulated. The property owner also has the opinion to sue you for breach of contract if you fail to buy the home. 

Which of these contract types is the right fit depends on what the housing market looks like at the time. If home prices are on the rise in the current market, you can lock in a price before they rise even higher with a lease-purchase agreement. On the flip side, if home prices are on the decline or stagnant, a lease-option agreement gives you a chance to have an appraisal at the end of the lease before you decide on a price. A real estate agent can help you make an advantageous choice here. 

When does rent-to-own make sense?

Rent-to-own agreements are a good option for aspiring homeowners who aren’t financially ready to buy a home just yet. These agreements give you time to get your financial life in order. You can use that extra time the lease provides you with to improve your credit score and save additional money for a down payment.

These agreements are best for those who already know where they want to live. If you find a home you can lease in an area that you love, is close to work, or has a great school district, then a rent-to-own agreement may work well for you. On the other hand, if you’re not entirely sold on the area and want to keep your options open, then a rent-to-own agreement can make you feel trapped for fear of losing your rent credits.

So, why would a seller want to go through all of this instead of going through with a traditional sale? 

If a seller struggles to sell their home and it sits on the market for a while, they can attract a potential buyer with the offer to let them build their credit and down payment over time. It’s important for sellers to get an idea of how strong the buyer’s credit is upfront. Even if the buyer improves it over time, the seller should make sure it’s in a good enough place right now that the buyer could qualify for a loan down the line.

Pros and cons of rent-to-own

Before you make a decision about whether or not a rent-to-own agreement is a good fit for you, take some time to consider both the advantages and disadvantages of such an agreement. 

Pros

• More time to improve your credit score. The higher your credit score is, the better your mortgage interest rates and terms will be. A rent-to-own property agreement gives you time to improve your credit score. Ask your landlord if they will report your monthly rent payments to the three main credit bureaus (Experian, TransUnion, and Equifax). That way, all your on-time rent payments will work towards improving your score. You can also use a service like ClearNow or PayYourRent to self-report rent payments. 
• More time to save for a down payment. During the lease, you will also have more time to save for your down payment. Your rent payments will help you build out your down payment, but you can also save additional money. Ideally you should aim to save enough to make a down payment that will qualify you to not have to pay private mortgage insurance (which lenders require for down payments of less than 20%). 
• Forces you to save. It’s hard to save money, especially when you’re working towards a goal as large as buying a home. A rent-to-own agreement forces you to save for your down payment each month, which will keep you on track. 

Cons

• You need to be able to secure a loan. At the end of your lease, you need to be able to get your hands on a home loan in order to purchase the home, unless you can make a full cash offer. If you fail to take out a loan and can’t buy the home, you’ll lose those rent credits and walk away without your down payment savings. 
• You must be able to make your rent on time. While you always need to pay your rent on time in order to stay in good financial standing, if you miss your rent by as much as a day under a rent-to-own agreement, you lose the monthly rent credit for that month. If you struggle to pay your rent on time, save a few months of rent payments before you sign a rent-to-own agreement so you can always make your payments.  
• You may feel stuck. If you aren’t fully confident you want to live in that area that the home resides in or you have doubts about the home itself, then signing a rent-to-own agreement is a bit of a risk. If you walk away, you lose all of your rent credits and you essentially overpaid to rent the home. Make sure you’re fully confident in a home and the surrounding community before you jump on board with a lease. 

Related: Learn how to save for a house while renting

The rent-to-own process isn’t for everybody, and it takes a lot of work to find a seller who wants to undergo such an agreement. But because renting-to-owning helps you save and plan for a down payment, some may find the whole process (hoops and all) to be worthwhile.