Rent to Own Agreement: Understanding the Basics
A Rent to own agreement, also called a lease-to-own agreement or lease-options, is a traditional lease agreement that also gives the tenant an option to purchase the rental property, typically a single-family house, sometime after the beginning of the tenancy. This arrangement has potential financial and other benefits to both landlords and tenants.
Components of the Rent To Own Agreement
A rent-to-own agreement is made up of two agreements: a standard lease or rent agreement, and an option to purchase; these may be incorporated into one document or two separate documents.
The Lease or Rental Agreement
In a rent-to-own agreement, the title to the house remains with the landlord until the tenant exercises his or her option and purchases the property. In other words, the starting point of this kind of an arrangement is a tenancy, not a house purchase transaction. The underlying rent agreement in a rent-to-own arrangement is therefore identical to a regular lease agreement between a landlord and a tenant, including terms such as the duration of the lease period, the amount of rent to be paid, and repair and maintenance responsibilities of landlord and tenant.
The Option to Purchase
An option to purchase grants tenant an option (right) to buy the rental property within a specified period in exchange for a fee (option fee). The fee is usually paid up front, and/or in the form of a higher-than-market rent (some of which is applied to the house purchase). A tenant who does not exercise the option to purchase is not entitled to a refund of the option fee or any refund in rent. Because so much is at stake for both landlord and tenant, it is crucial that the option to purchase covers all important terms and conditions such as the duration of the option period and the purchase price of the house. For more details about these key issues, see our article on Key Terms in Option-to-Purchase Agreements.
Obligations of Tenants and Landlords Under a Rent-to-Own Agreement
Here are a few ways a rent to own agreement varies from a traditional rent or lease agreement.
Payment of Rent and Setting Aside Monthly Rent Payments Varies
Just as in a standard lease or rental agreement, the tenant has a duty to make timely and exact payments of rent. In a rent-to-own arrangement, rent payments are often higher than they would have been had the transaction been a standard lease agreement because an agreed-upon percentage of the monthly rent is typically placed in an escrow account. It is the landlord’s duty to set aside the agreed-upon percentage of rent. The landlord either reserves the escrow funds and refunds the tenant upon purchase of the home or simply applies a percentage of the rent payments toward the principle of the house. In this manner, the tenant builds equity in the home throughout the duration of the lease agreement.
Tenant Makes Necessary Repairs to the Rental Property
Unlike a traditional lease, in which the landlord is typically responsible for making all repairs, rent-to-own tenants usually improve the rental property at their own expense. Many landlords and tenants consider this a fair bargain since, presumably, the tenant will eventually own the home.
Tenant Must Fulfill Lease Obligations
Until the tenant exercises the option and purchases the rental property, the premises are owned by the landlord. So, in addition to making repairs, the tenant must also comply with all other duties outlined in the lease. What this means is that the tenant must not have pets if the lease prohibits pets, must not house unauthorized residents, must not engage in criminal activities, and must not do anything else that is forbidden by the lease. If the tenant violates the lease, the option will become null and void. The tenant will likely forfeit both the option fee and the percentage of the monthly rent payments, depending on the terms of the option-to-purchase agreement.
The Tenant Should Inspect the House and Order an Appraisal
Although the tenant may never exercise the option to purchase the rental property, tenants should always inspect the premises and order an appraisal before signing a lease with an option to buy. Here’s why:
The future purchase price of the home is often agreed upon at the time the rent-to-own agreement is signed. An appraisal will ensure that the tenant is paying a fair price for the home.
A thorough inspection can determine whether the tenant will need to make future major repairs such as those to restore leaking roofs, broken HVAC, and heating units or clogged sewage drains, and help the tenant make the decision of whether entering into the agreement is sensible. In some states, landlords who lease a home with an option to purchase must disclose relevant information about the condition of the property, providing extra protection to tenants who are buying a home under a lease-option agreement.
Is a Rent To Own Agreement for You?
A properly-constructed rent-to-own agreement can be an optimal solution for both a landlord and a tenant.
Tenant Benefits of Rent-to-Own Agreements
A rent to own agreement could be a good choice for a tenant who wants to own a house and reap the benefits of home ownership but, due to bad credit or lack of capital (the typical 15-20% down payment required), does not qualify for a mortgage.
This type of arrangement allows a tenant to invest and build equity in a house while leaving open the option of walking away—for example if the tenant’s financial situation changes for the worse, or the tenant simply no longer wishes to live in or purchase the house. While there may be serious financial consequences (if the tenant paid a hefty option fee or has paid a lot of rent money into an escrow account), the tenant is not legally obligated to purchase the house under rent-to-own agreements. A decision to forfeit the option will not result in foreclosure proceedings and will not impact the tenant’s credit history.
Landlord Pros and Cons of Rent-to-Own Agreements
Landlords may benefit from a rent to own agreement or arrangement as well. Landlords who want to sell their rental property, but are having difficulty doing so, may find a buyer through a rent-to-own arrangement. During the option period, the landlord enjoys a reliable, long-term tenant, and usually does not have to deal with the expense and cost of maintaining the rental property. Also, if the tenant does not exercise the option, the landlord retains the option fee and the funds set aside in escrow.
Finally, landlords may also have various financial incentives for considering a rent-to-own agreement. For example, a landlord with a negative cash flow may find it advantageous to receive a small amount of cash now and regular income (in the form of higher-than-normal monthly rent), and tax advantages of this arrangement, as opposed to a lump sum payment from the sale of the property.
On the other hand, rent-to-own agreements have some downsides for landlords. Because they are unilateral agreements, the landlord is contractually obligated to sell the house to the tenant, if the option is exercised. The tenant, however, is not contractually obligated to purchase the house. Instead, the tenant may choose whether or not to exercise the option. The landlord is therefore bound by the agreement and may not sell the house to a third party during the option period.