Justin da Rosa
Home prices in Canada seem to be on a never-ending upward trajectory, pricing many people out of the market and forcing them to come up with creative ways to purchase a home.
Some are choosing to purchase smaller homes, others may borrow money for a down payment from family. Others are moving to far-flung areas of the country where houses are still somewhat affordable.
But, what about rent-to-own? Let’s take a look at this uncommon home buying method to see if it might be right for you.
What is rent-to-own?
Coming up with a down payment is one of the biggest hurdles to purchasing a home in Canada. Rent-to-own agreements allow potential buyers to save for a down payment while renting the home they eventually plan to buy.
Rent-to-own is an agreement between a tenant and landlord, where the tenant pays a set rent to their landlord, with a portion set aside for the purposes of building a down payment. Over time, the down payment grows and, eventually, the tenant is able to purchase the home outright off their landlord.
It’s a home buying method that allows a renter to save up for a downpayment and eventually own the home that they rent.
How rent-to-own works
To rent-to-own in Ontario, there are two agreements both the tenant and landlord must enter into. The first is a lease agreement and the second is an option to purchase agreement. The agreements cover things such as the lease term (i.e. how long you will lease the home), the rental price, the percentage of the rental costs set aside for a down payment, possession date of the property, the contract expiry date, and the home purchase price.
If you’re thinking of entering into a rent-to-own agreement, be sure to have your lawyer look over the contract to help you understand each of the requirements in the agreement.
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.
The pros of rent-to-own
There are various reasons why you might be considering rent-to-own. The main advantage of renting-to-own is that it allows a future homebuyers to address specific financial issues holding them back from obtaining a mortgage.
For example, renting-to-own can help you build up a low credit score. Instead of putting off a home purchase while repairing your credit, you can move into your future home and work towards saving a down payment while simultaneously building credit.
Another advantage is living in a home before purchasing it. You may take more pride in where you live, knowing it will one day be yours. It also allows you to “test drive” the home before fully committing.
The cons of rent-to-own
Rent-to-own doesn’t come without its potential risks. If you enter into a lease-to-own agreement and choose not to purchase the home, you will likely lose all the money accrued toward a down payment.
There may be some restrictions on what you can do to the property during the lease period since you don’t own it until you purchase it outright.
In situations where property values drop during the lease period, you will likely still be on the hook for the original purchase price. So, read your contract and understand the ins and outs.
Missing a rent payment may result in the nullification of the agreement and, as a result, the loss of the down payment savings.
Unless you negotiate a home inspection before entering into a lease-to-own agreement, there’s a chance you only uncover issues with the home after the purchase.
The buyer is required to qualify for a mortgage at the end of the rental period. That means, if any qualification issues persist, they may not be able to purchase the home.
Finally, while rent-to-own agreements in Canada are possible, they’re rare. That’s because home prices have seen historical price appreciation over the past decade. So, landlords who agree to sell at fair market value today for a sale that will close in a few years might lose out on potential appreciation.
Advice from the professionals
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.”
What about rent-to-own insurance?
While you’re renting, you’re not responsible for the building and other structures. That’s where landlord insurance is a requirement for the homeowner.
If you’re renting to own, it’s critical to get renters insurance to protect your belongings, legal protection if someone files a lawsuit against you, and living expenses if something happens to the building and becomes uninhabitable. Depending on where you live and how much stuff you want to protect, you can buy tenant’s insurance for between $12 - $30 a month.
Need home insurance?
The bottom line
Is rent-to-own a good idea?
If you’re struggling to obtain a mortgage, rent-to-own might be a good way for you to purchase a home eventually. However, it’s crucial to enter into a solid agreement where both parties are legally protected and understand the stipulations and requirements of the contract.
Do your due diligence. Speak to a lawyer and have them review all contracts before signing. Research the person or company offering the rent-to-own agreement to understand who you’re doing business with fully. And be prepared to hold up your end of the agreement to ensure a smooth and satisfactory homebuying process.