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Mortgage

What Are the Pros and Cons for Rent-to-Own?

If the prospect of getting approved for a mortgage puts your stomach in knots, a rent-to-own contract could help you get into a home of your own without the need to make a major commitment just yet. Depending on your financial situation, it might be something that makes a lot of sense—especially if you aren't quite financially ready to buy a home.

The National Association of Realtors reports that the national median price for an existing single-family home is $291,300. A 20% down payment here works out to over $58,000. Even if you qualify for an FHA loan that only requires 3.5% down, you'll still need upwards of $10,000. When much of your income is going to, say, rent an apartment, a down payment of that size could be years away.

With a rent-to-own agreement, you'll get a home to stay in and the option to buy it, which could help knock down some potential hurdles on the way to achieving the American Dream of homeownership. Understanding how it works is the first step in determining if it's right for you.

What Is Rent-to-Own and How Does it Work?

A rent-to-own contract allows you to rent a home for a specified period of time while providing you the option to buy it before the agreement expires. It essentially takes a standard rental agreement and bakes in the option to buy the property at a later date. Depending on the contract, a portion of your monthly rent payment could be put toward the eventual purchase price, helping you save as you go while building home equity along the way.

Rent-to-own contracts make the most sense for folks who know they want to be homeowners someday, but aren't yet ready to take the plunge. Whether you need time to improve your credit or save for a down payment, this type of arrangement can provide some breathing room while you get your financial house in order.

Rent-to-own contracts generally fall into one of the following two categories:

  • Lease option: You'll have the option to buy the home if you want to, but are under no legal obligation to do so. You can walk away after the lease is up if you change your mind.
  • Lease purchase: You'll be legally obligated to purchase the home at the end of the lease agreement. If you abandon the deal because you no longer want it or are unable to afford it, you could be in for a legal battle.

Going with a rent-to-own contract doesn't always make financial sense. One metric that can help clarify whether it's more affordable to rent or buy is something called the price-to-rent ratio. Begin by taking the median home price in your area and dividing it by your annual rent costs. If the total is below 15, continuing to rent could be more expensive than buying.

What Are the Benefits of Rent-to-Own?

As mentioned earlier, signing a rent-to-own contract can help you build equity in the home if it allows you to direct a portion of your monthly rent payment toward the purchase price. Over time, it can add up and amount to a sizable down payment that you may have struggled to save otherwise. Of course, every agreement is different, which is why it's always a good idea to read it line for line before signing.

These types of contracts are also ideal for potential homeowners who are dealing with short-term credit issues. If a less-than-perfect credit score is getting in the way of qualifying you for a mortgage, a rent-to-own contract could help you make movement toward buying a home while you take steps to repair your credit. Another perk is that you may be able to lock in the purchase price if the contract allows, which will give you peace of mind knowing the price won't go up at the end of the lease agreement. Knowing this ahead of time can also help you budget and save up a larger down payment in the interim.

Another detail worth mentioning is that you won't have to deal with the hassle or cost of moving once the lease expires because you're already living in the home. This could potentially save you thousands on everything from movers to supplies to furniture and more. And, if you decide you don't like the home by the time your lease is up, you don't have to go through with the purchase—as long as your agreement allows you to back out.

What Are the Downsides of Rent-to-Own?

There are some potential downsides when considering a rent-to-own agreement. For one, you may be on the hook for a nonrefundable upfront fee, although this is usually applied to your down payment when you eventually buy the home. Again, every contract is different, but 1% of the purchase price is a standard option fee.

What's more, if part of your monthly rent is indeed applied to your down payment, your rent will likely be higher than average for your market—sometimes to the tune of 10% to 15%. Your contract may also specify that you're responsible for property maintenance while renting. This could be a costly detail if your roof springs a leak or your air conditioning gives out.

When all is said and done, there's also no guarantee that you'll ultimately qualify for a mortgage at the end of the lease agreement. However, those who use their rental period to save, strengthen their credit and firm up their finances will be better positioned to qualify. Just keep in mind that if the owner defaults on their mortgage and the home is foreclosed on before you buy it, you could be forced to leave.

Another major downside is that you might sign a lease agreement that obligates you to buy the property at the end of the lease period no matter what. If you can't afford to buy the property, the legal requirement to buy it could land you in legal or financial hot water. Before you sign anything, carefully read it and make sure you understand it. If you have questions, consult an expert or attorney.

How Do Rent-to-Owns Affect Your Credit?

The only accounts that show up on your credit report—and, in turn, shape your credit score—are ones that are reported to the credit bureaus. Since rent-to-own agreements generally are not, they should have no impact on your credit. However, those who are looking to use positive rental payments to bolster their credit score could ask their landlord if they're open to reporting their payments.

If so, your credit score could go up if you simply make all your rent payments on time. Of course, it all comes down to personal responsibility—late or missed payments will reflect negatively. To improve the likelihood that you'll be able to purchase the property once the lease period is up, keep tabs on every component of your credit. Pay down debt as much as you can, continue making all payments on time and avoid opening new accounts unnecessarily.

The Bottom Line

Rent-to-own contracts are a unique financing tool that could make it easier for renters to transition into homeowners—assuming the individual terms and conditions make good financial sense. Like anything else, it pays to read the fine print and fully understand what you're signing before going all in. With that said, rent-to-owns can give homebuyers time to save up a solid down payment and improve their credit before making the purchase. This begins with knowing your credit score and what's on your credit report. Check it for free with Experian and take steps to get it moving in the right direction.