According to a recent survey from the Census Bureau, the median asking price for rentals across the country was roughly $1344 during Q3 2022. Compare that with data from the same survey stating asking price for new rents were roughly $1000 we can see that overall rent continues to skyrocket, leaving many prospective owners in a precarious situation.
Many want to own a home, but are hampered by the fact that a greater percentage of their “today” income is going towards their current rents. What is a possible solution for those that want to make that transition?
From the perspective of an owner and landlord, a rent-to-own home is an attractive potential feature for many potential renters. Structuring a rent to own contract is critically important though in order to protect you the owner and in turn the prospective renter.
With all that said, and the increasing potential market for people looking for a rent-to-own rental situation, what are some things to look out for as a landlord?
What’s Included in a Lease Option Agreement?
A lease option should contain several elements:
The purchase price is what you’ll pay for the home when you close the deal at some point in the future.
The term of the contract is how long you have to complete the purchase, typically one to three years.
An option fee is an upfront payment that you make when you’re considering buying a property. If you end up buying the property, the option fee becomes part of your down payment.
If you close on the purchase, the additional above-market rent paid to the seller will become part of your down payment.
Lease Option Pros and Cons
A lease-option agreement is different from a lease-purchase agreement in that it only gives you the right to buy the home, not the requirement. With a lease-option agreement, you make rent payments for a specified period of time before you have to make a decision on whether or not to buy the property.
Other advantages of a lease-option agreement include:
- When home values are escalating, you lock in today’s price and buy later.
- Rent credits force you to save up a down payment for your home.
- You can avoid a move by renting and then owning the same house.
- You may be able to purchase even if you don’t qualify for a traditional mortgage.
But there are distinct drawbacks, too. Some of the biggest risks that come with rent-to-own homes include:
- The home’s value may appreciate higher than seller expects, and they could refuse to sell.
- The home’s market value could fall lower than sales price, and the tenants decide not to purchase.
- Tenants may not qualify for a mortgage to complete the purchase at the end of the lease agreement.
- Tenants could breach the contract and sellers cancel the sale, keeping the potential buyer’s option money.
These are big risks. A lease option is only a good idea if you’re confident you’ll be able to get a mortgage at the end of the rental term, and that your priorities for buying a home won’t have changed.
Additionally, be certain you’ve reviewed the contract with a certified lawyer or estate agent, to be wholly cognizant of the terms and what will occur if the sale falls through.
What Is Seller Financing?
Seller financing is a type of financing in which the seller provides the buyer with a loan, rather than the buyer obtaining a loan from a third-party lender. Lease options and rent-to-own homes are both types of agreements in which the buyer does not immediately purchase the home, but has the option to do so at a later date. With seller financing, you complete the home purchase upfront. You don’t have a rental agreement or a traditional mortgage loan.
Instead of making a lump sum payment for a home, you make regular monthly payments to the seller until you can refinance the property, pay off the loan, or sell the home.
The agreement you have with the seller can be anything from a few months to a full 30-year mortgage.
When you finance a home purchase through the seller instead of a bank or other lender, you can avoid paying certain fees. However, this type of financing can also be much more expensive overall. For example, the interest rate you receive may be much higher than what traditional lenders could give you.
If traditional lenders are not willing to finance your purchase, the seller may be willing to do so.
The contract you sign will include the terms of the purchase, such as what is included, the total cost, and the closing date. It will also list the terms of the loan, like the interest rate, monthly payment, due date, and late penalties.
There are fewer protections for consumers and government regulations when dealing with private or owner financing.
If you aren’t knowledgeable about your local real estate market or the process of securing financing for a home, you should consult with a Realtor or real estate attorney before making a purchase from a seller who is providing financing.
Structuring & Offering Lease-To-Own Deals
Future homeowners will often purchase their next residence with a mortgage and a down payment. If a potential buyer is having difficulty securing a mortgage due to their income or credit score, what are the options? What if you don’t want to pay thousands of dollars in interest payments to the bank? There is a way to purchase or sell a home without the bank being involved. How to Structure and Offer Rent-to-Own Home Deals
- Draft a Purchase Price Agreement
- Create a Rental Agreement
- Apply Rent to Principal
That may sound a bit strange to American consumers who are almost universally taught to believe that a down payment and a mortgage is the only way to buy a home.
How Rent-to-Own Homes Work
It allows you to rent a property for a set period of time – often three to five years – with an option to buy it at any point during those years. A rent-to-own arrangement, also known as owner financing or seller financing, is a type of deal in which you rent a property for a set amount of time, usually 3-5 years, with the option to buy it at any point during that period.
Though some of the steps for buying a house without using a real estate agent are similar to those when working with an agent, there are a few key differences. Most notably, you won’t need to work with a bank or lending institution. Buyer and seller will communicate directly to come to an agreement. When selling property, going through a real estate agent is beneficial for both the seller and the buyer. The seller has a better chance of obtaining the price they want and they have some leverage over the buyer. The seller can always refuse to sell to a buyer who needs a mortgage, and wait for an all-cash buyer instead. However, an all-cash buyer will have more negotiating power over the seller because they will be able to offer more money upfront. This could lead to a lower price for the property.
With this deal, the buyer will not purchase the property outright, but will instead rent the property from the seller with the rent going toward the purchase. This type of arrangement is more flexible for buyers who need financing to purchase a home. There are many reasons why someone might want to enter into a rent-to-own home arrangement. This could be because they are having difficulty getting a mortgage due to their credit history, income, or other factors.
For example, self-employed individuals may have difficulty securing a mortgage in the current lending climate.
There is a lot of room for negotiation between the buyer and seller in a rent-to-own situation. The down payments are often smaller. Interest rates, the length of the mortgage, and the final sale price can all be negotiated. It is quite an attractive arrangement for homebuyers. One of the reasons HELOCs are not more popular is because they usually only work when the seller owns the property in full.
How to Structure and Offer Rent-to-Own Homes
A rent-to-own home arrangement still needs to be structured legally to protect all parties involved, even though it does not involve a mortgage lender or real estate agent and their closing costs.
Purchase Price Agreement
Between the buyer and seller, the first step is to come to an agreement on the purchasing price.
This agreement establishes the home price and will transition to either a lease agreement with an option to purchase or a lease agreement with a purchase agreement.
At the end of a lease agreement with the option to purchase, the seller is allowed to walk away. The lease agreement includes a clause that obligates the tenant to purchase the home when the lease is up. The seller could even take legal action against the buyer for not following through with the purchase, if necessary.
This is an arrangement in which the buyer pays an amount of money upfront to secure the option of purchasing the home at the end of the lease term. The money for this rent-to-own situation is similar to a down payment on a traditional home loan. The only difference is that with a traditional home loan, the money transitions to the seller immediately upon sale of the home, whereas with a rent-to-own situation, the option money might stay in an escrow account until it is time for the sale, which could be several years.
Rent-to-own agreements are typically not long-term. The agreement for purchasing a rent-to-own home could require a lump sum payment that is spread out over 30 years, with a balloon payment due after five years.
Next comes the rental agreement. This will be a rental for some time.
The role of landlord and tenant are more unclear in a rent-to-own arrangement than in a traditional rental situation. If the terms of the rental aren’t agreed upon beforehand, that could lead to conflict.
The rental agreement should clearly state who is responsible for maintaining the property and what specific tasks they are responsible for. It’s a good idea to have an attorney who knows about real estate asset management draft any agreements related to this area to avoid any confusion.
The monthly rent in a rent-to-own home deal can be set by the two parties involved, but it might be subject to guidelines that spell out the market rent in the area or what a monthly mortgage payment might be if the buyer got a traditional mortgage loan.
This rental agreement should also specify how long the lease is for the rent-to-own home. At the end of the lease term, it is not a bad idea to reference what will occur. This will depend on whether there is a lease-purchase agreement or lease option agreement in place, as mentioned earlier. The contract for a lease option or lease-purchase should be its own separate contract.
Apply Rent to Principal
When negotiating a rent-to-own home agreement, it’s important to discuss who will be responsible for making the payments.
Traditionally, a quarter to a third of the monthly rental payment is credited towards the eventual purchase price of the home, with the rest paying for the use of the home itself. This section can cover topics such as maintenance costs, property tax, the owner’s mortgage on the property (if relevant), insurance, and interest.
The following text discusses a financial strategy whereby a seller avoids paying a capital gains tax by selling an asset using a rent-to-own arrangement.
Rent-to-own homeowners who are unsure of how their monthly rent payments should be applied should consult with a lawyer to determine what, if any, laws are relevant. The rent-to-own home agreement in your city or state may be structured differently due to affordable housing laws.
Predatory Sellers and Rent-To-Own Scams
Some sellers do not want you to complete the purchase, according to a study.
Some sellers include clauses that allow them to cancel the deal if you are late on a payment, and they get to keep all of the money you paid as well as the rental credit.
If you have an agreement with a landlord, you may be responsible for covering maintenance and repairs that the landlord would normally be responsible for. If you can’t keep up with the maintenance, you could lose your money to the seller.
In a study completed recently, it was estimated that only 20% of people who enter into a rent-to-own home contract end up actually purchasing the home. The people who were trying to buy homes either had to move out, losing the money they put towards the home, or they ended up in foreclosure with a mortgage they couldn’t afford or a home that was worth less than they paid for it.
Potential buyers should also be wary of scams. Before agreeing to a rent-to-own deal, it is important to find out who owns the home. This can be done by doing a title search or looking up the tax records at the local courthouse.
If the person you enter a lease-option agreement with doesn’t own the property, they may be trying to scam you out of your upfront money.
Make sure you inspect the home thoroughly before agreeing to any maintenance, especially if your purchase option is contingent on the home’s condition.
Be sure to retain a lawyer.
You may be tempted to forgo legal representation if you are entering into a lease option or an owner-financed contract, because these types of contracts typically do not involve mortgage lenders and can feel less formal than a traditional sale.
Don’t. The rent-to-own process is riskier for buyers than traditional transactions. You’ll need adequate representation.
You should consider hiring a real estate attorney to help you with your case. If the seller has someone smart working for them as well, you could end up paying a lot of money – both at the beginning and at the end of the lease agreement – if you’re not careful.
Your attorney can review your purchase agreement with the seller to identify any clauses that could unfairly cancel your option to purchase the home.
An attorney can investigate the county records to ensure that the home you want to purchase is not being foreclosed, has no liens, and is owned by the seller.
Your lawyer should document your lease option or purchase with your county recorder.
This will stop the vendor from being able to move the ownership of the property to anyone else while you’re in the process of buying it from them. The due diligence period will protect you from the seller getting extra mortgages on the property without you knowing.
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