How Do Rent-to-Own Situations Actually Work?

by Grainne Burns December 8, 2014 / No Comments

At quick glance, the words “rent-to-own” might sound perfect for some hopeful homebuyers. This option allows you to live in your dream home, slowly save the down payment for it and get the rest of your finances in order, so you can buy the property later.

There are no bidding wars. No fear of big price hikes. It sounds great, right? So, why isn’t everyone jumping on board and getting this type of property? Because, while it can prove successful for some people, there are a lot of risks and costs associated with these transactions.

Before we jump into those, let’s set the stage for how this works. Someone already owns this home, but has decided they want to sell it. If they are having trouble doing so, they may decide to go the rent-to-own option instead, so someone is at least giving them money to cover the monthly mortgage payments on the home.

The owner and tenant sign an “Option to Purchase Agreement”, where, for a fee, the tenant can live in the home and save up the required down payment, during a set period of time (let’s say 3 years). This fee, also known as the option deposit, ranges from 2.0-2.5% of the purchase price and is later deducted from the agreed purchase price. So, the tenant needs some cash upfront, to get started.

While living in the home, the tenant must pay the agreed upon rent amount each month, as well as put additional funds aside for the 5% down payment due in 3 years. Ideally, these funds should be paid into an account that the landlord cannot access.

Here’s an example how things might look, when setting up a rent-to-own situation:

Agreed Purchase Price: $290,000
Option Deposit: $290,000 x 2.5% = $7,250 (due before the tenant moves in)
Amount Owing After 3 Years: $290,000 – $7,250 = $282,750
5% Down Payment Required: $282,750 x 5% = $14,138

Monthly Rent: $1,300
Extra Funds for Future Down Payment: $450/month
Down Payment Saved After 3 Years: $450 x 36 months = $16,200
Amount Leftover After Putting Down 5%: $16,200 – $14,138 = $2,062

In this example, by entering a rent-to-own situation, the tenant will pay $46,800 in rent over 3 years, while saving $16,200 for the down payment. After putting just 5% down ($14,138), they’ll have a little extra leftover, which they could also put down or save for their additional closing costs.

If you’re worried that home prices will continue to go up in the future, one advantage of entering a rent-to-own situation is you get to pre-determine the purchase price a home a few years before you actually buy it. A word of warning, though. Many owners now include a clause in the contract that states, if home values rise significantly, tenants may have to pay more in the end. For this reason, some tenants may find themselves unable/unwilling to purchase the home, after all.

“I would personally not recommend [rent-to-own situations] to buyers unless it’s the very last option available to them,” advises James Laird from CanWise Financial. “If the renter does not end up exercising their right to buy, they lose a lot more cash [the option deposit] compared to just renting and saving for a down payment on their own.”

People with bad credit ratings or income issues may be drawn to this buying strategy. Unfortunately, many still find it difficult to get financing at the final hurdle (when they sit down with a mortgage broker or lender). One reason for this may be the fact that some buyers won’t have any other assets/savings, since much of their income was being used to pay rent + save for their future down payment on the home.

“The key to making rent-to-own situations work is making sure that the issues that are currently preventing you from buying a house are solved by the time your option to purchase presents itself,” says Laird. “At the end of the rent-to-own period, when the renter goes to exercise their right to buy, they may have trouble finding a lender willing to finance the property because they are hesitant to lend on properties that are being purchased out of a rent-to-own agreement.”