How does rent-to-own work?

Key takeaways

• Rent-to-own can help renters become homeowners, especially if they need time to build credit or save for a down payment, but these agreements are more complex than standard leases.
• Upfront fees and monthly rent credits are often nonrefundable, meaning you could lose money if you can’t, or choose not to, buy the home at the end of the contract.
• Contract details determine the risk, so buyers should review the terms carefully, confirm responsibilities such as repairs and taxes, and have an attorney review the agreement before signing.

Renters who are hoping to become homeowners might have come across a rent-to-own option. Such arrangements can seem tempting if you don't have enough for a down payment, have bad credit and can't get a mortgage approved. But while this option can make homeownership a reality, some agreements come with risks and can be complicated.

Rent-to-own is when someone has the option to buy their rental property after renting it for a few years.

"As a renter, you would typically create no ownership position with your monthly payments," said Cody Schuiteboer, president and CEO of Best Interest Financial, a mortgage company in Detroit, Michigan. "However, with rent-to-own, a portion of your monthly payment is applied to your future down payment."

These agreements are laid out at the beginning of the lease, so the price is set years before the deal is executed.

"With a lease-option, you rent a house along with a contractual option to purchase it in the future under specific terms," said Shane Lucado, an attorney, founder and CEO at the legal services firm InPerSuit based in Birmingham, Alabama. "Typically, you’ll pay ‘rent’ that includes the market rent plus an additional $300 or so per month intended to count toward the purchase price down the road."

The additional money paid each month will be credited toward the purchase. This helps people slowly "save" for the down payment necessary to buy the home.

When the agreement is set, the total purchase price is fixed, with some flexibility for inflation.

"The purchase price is either guaranteed at the time of signing or tied to an index with a preset formula, say 3 percent annual growth," Lucado said. "That means rising markets tend to favor the buyer and stagnant markets favor the seller. If you bail on the deal, you typically forfeit your option fees and whatever monthly credits you’ve accumulated."

These agreements work best for renters who plan to become homeowners and stay in their current home for five or more years.

One of the pros of renting is the flexibility to move. Breaking a lease is a lot easier than selling a home. The lower financial commitment of a lease is great for people who are not sure where they want to live in one or two years’ time. But if you feel confident that you will be in an area for a long time, then a rent-to-own option could be ideal.

Rent-to-own is also a good option for people with poor credit and limited savings for a down payment, since these are factors mortgage lenders consider when granting loans. Talk to a mortgage lender and examine if buying traditionally is possible for you before looking at rent-to-own.

If you are looking to rent-to-own, there are a few ways to find a place. You might come across a property on rental listings or you can use a real estate agent or broker to locate places.

Signing a rent-to-own agreement is a more significant commitment than a typical rental lease, and it should be approached with the scrutiny you would bring to buying a home. Vet the property and consult professionals to ensure the agreement is sound and that you can afford it.

"Before signing any rent-to-own contract, you should have an attorney look over the agreements," said Schuiteboer. "Real estate agents find properties for you. An attorney looks out for you by ensuring any agreements are fair and legally defensible. I encourage my clients to work with an attorney and a mortgage lender before signing."

A mortgage doesn't come with a rent-to-own contract. But it's important to know whether you can afford one in the long run. You will need to have a mortgage at the end of the contract, so speaking with a lender before entering the agreement will help ensure you will be able to qualify when the time comes.

Don't enter into a rent-to-own agreement without carefully reviewing the terms. This includes establishing who is responsible for insurance, maintenance and taxes during the contract.

“The devil is in the details of the agreement," said Rebecca Hidalgo, CEO and designated broker of the real estate firm Integrity All Stars Realty in Chandler, Arizona. "Make sure you don’t agree to something you can’t do. If the payment stretches you and life happens, you can really get screwed over. Don’t push your budget.”

Rent-to-own is not without risk. It’s very similar to buying a home, but it requires less upfront cost and a lower financial standard. You will likely undergo a credit check and provide proof of employment and funds to pay the monthly cost.

You might pay an option fee, a non-refundable payment that confirms your right to purchase the home under the rent-to-own agreement. It is like a security deposit, but it will go toward your credit for the down payment.

Once you have signed the agreement, you will pay the agreed-upon rate for the agreed-upon period. Once that time period is up, you will have the right to purchase the home.

The risks associated with rent-to-own depend heavily on the contract.

“Every deal is different," Hidalgo said.

One possible risk is reduced options. Most homes for sale do not offer a rent-to-own option, so you will likely be limited to fewer homes to choose from.

The biggest risk is losing your investment in the property if something changes and you don't go through with the purchase. This means you will lose the option fee and the extra monthly money you paid, which were credited toward the down payment. This will be different for each contract.

If you are in a lease-purchase rent-to-own contract, you will be required to buy the home at the end of the agreed-upon timeframe. If you back out of this type of contract, you will lose the money you invested and could be sued by the owner for breaching the agreement. When signing this type of rent-to-own contract, you are agreeing to buy the home at the start of the contract.

A lease-option agreement gives you more flexibility to back out of buying. You might still lose some money, but you can leave the agreement without facing legal consequences. You will have until the end of the contract term to decide whether to proceed with the purchase. The contracts typically last one to three years.

Higher monthly payments could strain your budget, so making sure you can afford the rate is very important. It’s also important to budget for the additional costs if you are responsible for maintenance, taxes or insurance.

The purchase price is likely locked, which can either benefit you or hurt you, depending on the market in the area.

"The most significant risk is entering into a rent-to-own agreement with purchase prices that are inflated and exceed the home's fair market value," Schuiteboer said. "Other vital risks include predatory contracts in which, if you don’t purchase, the rent-to-own company keeps your equity credits and maintenance costs, a large HVAC or roof replacement costs $8,000 to $15,000, and you inherit undisclosed, serious property issues."

With many factors that expose you to risk, it’s advised that you ask a lawyer to review the contract to protect your interests.