How does rent-to-own work? A comprehensive guide

Homeownership is an exciting journey and a rewarding financial goal. From the thrill of finding one's dream home to building memories, it's a significant milestone many people are working toward. It can also be one of the most challenging to reach, requiring good credit and a large down payment beyond the reach of many hardworking families.  

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At the same time, there are many homeowners out there looking to sell second properties that they own, but market conditions may not be favorable, or they may prefer to dabble in passive income before divesting from their property completely.

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In cases like these, a rent-to-own agreement can help both the would-be homebuyer and seller achieve their mutual goals. But how does rent-to-own work? Is rent-to-own a good idea, from both a buyer’s and a seller’s perspective? These non-traditional real estate transactions require extra forethought and diligence, but when done right, they can be instrumental real estate strategies.

What is rent-to-own?

If you’re a traditional renter, your rental payments go solely to your landlord, and you lose the chance to build wealth through home equity toward the eventual purchase of a home. A rent-to-own agreement, by contrast, is structured to divert some of your rent payments toward the eventual purchase of the home you’re living in. It’s a bit like a layaway plan to purchase the home you rent.

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Rent-to-own agreements are not common because your landlord, by definition of the contract, may eventually lose their source of passive income if you end up purchasing the home. That’s why rent-to-own agreements are often negotiated directly between the renter and the homeowner, who serves as the landlord while the home is being rented. As a result of rent-to-owns operating on a contract basis, there are no standards or rules governing them aside from a few state-specific laws.

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This also makes rent-to-own agreements more variable — and negotiable — than a traditional mortgage. Good real estate agents can help connect rent-to-own partners, although several new startups, such as Divvy and Home Partners for America, may also offer this service for interested buyers for specific homes.

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Most rent-to-own contracts fall into one of two camps: lease-purchase or lease-option, which both work similarly except for one key detail. Under a lease-option agreement, you can walk away and decline to purchase the home at the end of the contract. You don’t get that choice with a lease-purchase agreement: you’re obligated to buy the property when the contract ends.

Rent to own for buyers

Many renters rush into rent-to-own agreements because it can seem like the only way forward to homeownership if you’re unable to buy a home via traditional routes. However, a rent-to-own agreement requires more caution because if it doesn’t work out, it could actually set you back even further on your path to becoming a homeowner. Let’s see how it works.

How does rent-to-own work for buyers?

A rent-to-own agreement comes with more additional costs, responsibilities, and repercussions than a traditional rental. Most rent-to-own contracts require an up-front Options Fee that gives you the right (or requirement, depending on your contract type) to purchase the home. This Options Fee typically costs between 1% and 5% of the value of the home and is due at lease signing.

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Your contract will also dictate how much of your rental payments accrue toward your eventual down payment, typically 10% to 15%. These are known as Rent Credits, and they’re generally factored into your monthly payments so that you’ll be paying higher-than-market-rate prices for the home you’re renting.

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Your contract will dictate when you can purchase the home and what it will cost. Most rent-to-own contracts allow you to purchase the home at the end of the contract, but you may be able to do so sooner. Some rent-to-own contracts lock in a certain price, typically above current market rates, to account for appreciation. Alternatively, the sales price may be determined through a home appraisal at the time of purchase.

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A typical rent-to-own agreement lasts for one to five years, during which time you’ll need to focus on ensuring you qualify for a mortgage. When the time comes, your landlord can supply you and your mortgage lender with documentation outlining your Rent Credits and Options Fee amount, which will be applied toward your home purchase.

Benefits of rent-to-own for buyers

• Try before you buy: Renting-to-own allows you to try out living in the home and the neighborhood first before you commit to a much larger investment.
• Built-in savings plan: Your Options Fee and Rent Credits generally count toward a down payment for the home you’re buying, a de-facto savings plan if you’ve struggled to save in the past.
• Hedge against competitive markets: In a seller's market, where buyers son't have the upper hand, finding and purchasing a home can be difficult  — whether from limited supply or affordability. When you reserve a home for purchase, you're protected against this uncertainty.
• Incentive to build credit and improve finances: A rent-to-own agreement gives you a defined date for when you’ll need to be ready to qualify for a mortgage, which can serve as the extra motivation some people need to take action.

Disadvantages of rent-to-own for buyers

• Fewer choices: You’ll have a limited pool of options to purchase a home through a rent-to-own agreement.
• Lawsuit potential: If you sign a lease-purchase agreement that requires you to buy the home at the end of the term and you aren’t able to qualify for a mortgage by then, your landlord may sue you for breach of contract even though it may not be your fault.
• Still very expensive: Rent-to-own agreements aren’t as costly as purchasing a home with a full down payment, but they’re still not cheaper than renting alone. You’ll pay thousands of dollars upfront to even get in the home, with ongoing high rent costs.
• High wealth loss potential: Rent Credits and the Options Fee are nonrefundable, meaning you risk losing thousands of dollars if you decide not to purchase the home. If your landlord defaults through no fault of your own, you could still lose this money.
• Stricter late payment policy: It’s important to be clear on what happens if you pay late before signing the contract. The terms of some contracts dictate that even one late payment can mean you lose the option to purchase the home and your cash savings.
• Maintenance and upkeep requirements: Most rent-to-own contracts require additional responsibility on your part for regular upkeep, such as mowing the lawn, and even to pay for repairs out of your own pocket.

Rent to own for sellers

Many sellers prefer traditional simple real estate transactions without the added rent-to-own provisions. However, selling your home via a rent-to-own contract can provide a lot of advantages, particularly if you aren’t in a hurry to sell the home and want an additional stream of passive income while you wait for better market conditions that may fetch you a higher price.

How does rent-to-own work for the seller?

A rent-to-own contract works the same way as outlined above for the buyer, except you’ll be taking the place of the landlord. That means you’ll need to find and vet a tenant looking for a rent-to-own home and create a contract. During the rental period, you’ll need to stay in touch with your tenant so that you can collect rent, enforce any contract provisions such as late payments, and establish a smooth hand-off at the end of the process.  

Benefits of rent to own for sellers

• Earn passive income: You’ll get a consistent stream of income during the interim, which you can use to help you reach other financial goals or even to purchase a second home. If your tenant doesn’t purchase the home, you’ll also get to keep the Rental Credits and Options Fee as profit.
• Higher-quality tenants: Your tenants have a vested interest in maintaining the home’s value and are thus more likely to take care of it than a traditional renter.
• Fewer maintenance costs: Depending on the terms of the rent-to-own contract you agree on, your tenant will generally share in the burden of maintaining your home, freeing up more of your monthly income.
• Higher potential sales price: If your contract is structured to offer the home for purchase at market-rate prices and home values increase during the rental period, you may gain a higher profit than if you sell it now.
• Help expand homeownership access: You may be helping a family purchase a home that otherwise wouldn’t be able to do, especially in current market conditions.

Disadvantages of rent-to-own for sellers

• Loss of asset: If everything goes according to plan, you’ll eventually end up selling the home and losing out on rental income potential.
• Requires patience: You can’t walk away from your rental like you can if you sell your home outright. You’ll need to ride out the relationship — highs and lows included — for up to several years.
• Can’t accept higher offers: If a potential buyer offers you a higher purchase price down the road than your tenant would pay, you can’t accept it because you’re contractually obligated to sell it to your tenant.
• Possibility for tenant turnover: You may need to find another tenant if your current one decides not to purchase the home. Additionally, you may need to sue a tenant if they breach the terms of the contract, such as by not buying the home in a lease-purchase.

Is rent-to-own a good idea?

There is no one-size-fits-all answer to this question. A rent-to-own contract can be a good idea for some people but can be disastrous for others.

A rent-to-own contract can be a great idea for renters if you find a home you really love but aren’t able to purchase right now. It can also be good if you aren’t too picky about where you live but want to limit the number of moves you make while working to qualify for homeownership.

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In any case, it’s essential to take a deep dive into your finances to see if a rent-to-own agreement aligns with your financial goals compared to your other options. Can you afford the higher rental costs of a rent-to-own agreement? Will improving your credit score by the time you need to purchase the home be feasible? Would you be comfortable with losing your Rental Credits and Fees if you walk away from the home? How would a rent-to-own agreement compare to saving up on your own with lower rent costs or using an alternative mortgage such as an FHA loan?

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As a seller, consider whether you’re willing to handle the additional work of creating and navigating a rent-to-own relationship with your tenant-turned-home buyer. If your motives are to ride out a difficult seller’s market until you can earn a higher sales price, would you still be able to handle selling the home at a reduced price if conditions don’t improve? If you’re simply looking for short-term passive income, could you use the proceeds from selling your second home to invest in another venture?

Tips on getting the most from a rent-to-own agreement

• Watch for scams: Thieves target would-be renters at higher rates because they know that people interested in rent-to-own homes may be more desperate to become homeowners. Make sure to familiarize yourself with warning signs of scams, such as being offered a run-down home.
• Get the law on your side: Sellers should hire a real estate lawyer to draft a contract that meets legal standards. Buyers should hire their own real estate attorney as well to explain the contract terms in plain English and note any deviations from industry standards or potential negotiation opportunities.
• Do your due diligence: Buyers should take some of the preliminary steps to buy a home now, including getting a home inspection and title search done. This can flag any issues that might cause you to decline the home purchase if you were buying now.
• Get credit for rent payments: Ask your landlord to report your rent payments to each of the three credit bureaus, which can give you a big boost in building credit toward the eventual purchase of your home.
• Get clear on maintenance: Tenants generally share in maintenance costs, but it’s important to be clear on what exactly. Fixing a cracked foundation is a very different thing entirely from fixing a cracked showerhead.
• Consider alternatives: A rent-to-own agreement is far from your only option to buy a home if you can’t qualify right now. In addition to simply saving up more, you may be eligible for special mortgages with low- or no down payment, down payment assistance programs, credit counseling, etc.

Final thoughts

Rent-to-own agreements, when done correctly, can offer a win-win scenario for both the renter/buyer and the landlord/seller. In order to ensure that happens, it’s especially important to consider the pros and cons carefully and for renters to draft a concrete plan to ensure they’re able to purchase the home within the term of the contract.