How Lease-to-Own Homes Work: A Guide
If you’ve been dreaming of moving into a home but your credit score isn’t good enough to qualify for a mortgage, a lease-to-own rental agreement might seem ideal. Before you dive in, however, you should consider the many pitfalls of lease-to-own agreements, along with what to consider before, during, and after you start the process.
A rent-to-own home might seem like it’s your only path to homeownership, but that doesn’t mean it will leave you better off. Keep reading to learn more about lease-to-own homes, how the process works, and what to watch out for.
What is a lease-to-own home?
If you want to own a home but can’t get a traditional mortgage, leasing a home with the option to buy is one way to achieve your goal of homeownership. With this option, the rent you pay during your lease will actually build equity in the home. If you complete the agreement to a “T,” you may even own the property in the end.
Generally speaking, lease-to-own homes, or rent-to-own-homes, come with a standard lease that includes a provision that makes it possible for the renter to purchase the property after a few years.
There is no standard lease-to-own contract; each one is unique, and the arrangements can be complex. Where some lease-to-own agreements can last decades, others require the renters to purchase the home after a few years.
When a lease-to-own agreement is in place, you’ll begin making your monthly installment payments to the property owner, similar to paying rent to a landlord. Once time is up on your agreement, you’ll have the option to purchase the property. Typically, the buyer will then get a mortgage to cover the remaining purchase price of the property, less their option consideration and any rent credits they have.
If you’re considering this kind of agreement, you should consider whether your credit score will be good enough to qualify for a home loan in the future. If you cannot qualify for a home loan once your lease-to-own agreement is up, you’ll forfeit all equity in the property.
It’s important to consider situations where lease-to-own homes might be ideal for you as a homebuyer — and when it isn’t.
Generally speaking, lease-to-own homes work best for individuals and families who meet the following criteria.
- They have poor credit that renders them unable to get a traditional mortgage.
- They are dedicated to purchasing a specific property and are in it for the long haul.
- They want to stop throwing rent money away and start building equity.
- They know they want to buy a home, but they’re not quite ready.
If you think a lease-to-own agreement sounds perfect, it’s important to note that these agreements come with their own share of downsides and potential risks as well. While we’ll dive deeply into some of the major risks to consider later in this guide, some of the basic pitfalls to be aware of include:
- You may have to pay upfront fees and especially high rent payments.
- A single missed payment can cause the deal to expire, even if you have paid on the home for years.
- Since nobody knows what the home might be worth toward the end of your deal, you may wind up making payments over the years that amount to more than what the home is actually valued at.
- If you make it to the end of the lease-to-own term and still need a mortgage to pay off the rest of the loan, there’s no guarantee your credit will be good enough to qualify.
While lease-to-own homes have their share of potential problems, the best way to avoid falling victim to a scam is understanding your lease-to-own purchase agreement fully and completely.
While all agreements are unique, here are the most common provisions to look for and how they work.
Lease or rental agreement. In a lease-to-own rental agreement, the title of the property remains in the name of the landlord until the renter-buyer exercises their right to purchase the property. As a result, the underlying agreement of any lease-to-own contract is similar to a traditional rental contract. Typically, these contracts include an agreed-upon rental amount, a specified duration of the lease period, and an outline of who is responsible for repairs and maintenance responsibilities.
How the purchase price is determined. “The most important part of these agreements is how the purchase price is determined,” says Casey Fleming, a San Francisco-based mortgage expert and author of “The Loan Guide: How to Get the Best Possible Mortgage. “In some cases, it’s determined using a formula based on some level of appreciation, but it can also be a set amount that is decided ahead of time.” Either way, you’ll want to make sure the terms are clearly stated in your agreement.
Maintenance requirement. Most lease-to-own agreements include provisions that leave the new renter-buyers in charge of all home maintenance. That usually means basic maintenance needs, like landscaping and cleaning, but Fleming says it’s important to ask the seller to be specific about what you’re responsible for in the contract. Generally speaking, property owners are still in charge of major component replacements and repairs. “But this is all negotiable,” says Fleming. “This is why you need to make these provisions crystal clear.”
Late payment penalties. In order to receive your rent credit (equity paid through monthly rent payments), you must pay your rent on or before the due date stipulated in your lease. If you’re late, it’s likely that 0 percent of your rent will be credited to your home purchase that month, and that you’ll be hit with a late payment fee as well. “The strictness of these rules vary by agreement, but often include a clause that requires all on-time payments or your excess payments will be lost,” says Fleming.
Lease-to-own provisions. Agreements must specify what percentage of monthly rent will apply to the purchase of the home.
Rent credit. A portion of the rent is typically applied to the eventual purchase. This percentage of money or rent is called a rent credit. Again, not all contracts include a rent credit, and it’s negotiable.
Also, a negotiated percentage of all rent payments should be applied toward the purchase of the home. The percentage of rent applied is negotiable and will be outlined in the formal lease agreement.
Option to purchase. Lease-to-own agreements include an option to purchase the property within a predetermined length of time.
Brian Davis, consumer advocate and director of education at SparkRental.com, says it’s important for buyers to understand that most rent-to-own contracts include an option to purchase — not an obligation. Usually, this is indicated by the terminology “lease-option agreement” instead of a “lease-purchase agreement,” notes Davis. However, renters should be crystal clear ahead of time about whether they’re obligated to buy the home.
As Davis notes, you should ask what happens if you decide not to purchase the home after all. Do you simply lose your option to buy? Are there any penalties? Are you forced to move out?
According to the legal experts at NOLO, key provisions that must be included in the option-to-purchase provision include: the option fee, the duration of the option period, and the purchase price of the house. The option to purchase must also be written in accordance with state and local laws.
This fee will be forfeited if the buyer is unable or unwilling to buy the property.
In some states, however, the option consideration is built into the monthly rental price, says Fleming. “Every state is going to be a little different, so that’s a tough one to say from state to state,” says Fleming. “What I normally see in the Bay Area is a premium over and above the market rent that is credited toward the down payment as long as the buyer exercises their option to buy within the given time frame.”
Either way, Fleming notes that a fair contract will credit the buyer 100 percent of that option consideration upon closing of the sale. So if you make it through the sales contract from beginning to end, the upfront fee or rent overages you pay will be credited toward the home purchase.
While there are plenty of reasons to consider a lease-to-own agreement when purchasing a home, it’s important to know the risks and potential downsides, too. Unfortunately, rent-to-own purchase agreements and the buyers who choose them have seen their share of scams over the last few decades. Further, many landlords have been found executing lease-to-own agreements that are predatory.
Some investors target low-income families, immigrants, and minority buyers with purchase agreements that are doomed to fail.
A 2016 report from the National Consumer Law Center (NCLC) showed how some large investment firms used lease-to-own agreements to profit off of a backlog of foreclosed homes after the Great Recession in 2009.
Targeting low-income households, immigrants, and people of color, companies offered lease-to-own agreements as a way to avoid responsibility for property upkeep. By offering contracts that put renters in charge of repairs and maintenance, investors are able to sidestep their liability to make these repairs themselves.
By focusing on low-income and unsophisticated buyers, investors can use lease-to-own agreements to sell homes to a merry-go-round of buyers who let their homes slip into default after finding they can’t afford pricey repairs. Their rent and deposits are forfeited to the property owner in this case, who often continues renting out the same home to new buyers who face the same fate.
Depending on how they’re written, these agreements are often risky, almost always lack consumer protections, and may not even be enforceable in some states.
According to the NCLC, these contracts are popular with investors because they make it easy for buyers to go into default “since traditional mortgage foreclosure protections do not apply.”
For example, under the Consumer Financial Protection Bureau’s (CFPB) rules, delinquency begins on the date after a borrower’s housing payment becomes late. But when a borrower misses a period payment and later makes it up, “the date the borrower’s delinquency began advances.” This can buy consumers more time to get back on track with their mortgage before facing foreclosure.
Additional mortgage protections ensure that, under certain circumstances, loan servicers have the option to consider a borrower as having an “on-time” payment even if their payment “falls short of a full periodic payment.”
Further, new rules from the CFPB dictate that mortgage servicers are required to extend foreclosure protections to borrowers in default not just once, but multiple times, after they have brought their loan current since submitting the prior complete loss mitigation application, which is a form completed by the homeowner and the loan servicer prior to the foreclosure process.
With a lease-to-own agreement, on the other hand, renters who make a late payment may not have any recourse at all, as their agreement can end the moment they miss a mortgage payment.
According to the Federal Trade Commission (FTC), the lack of government oversight on lease-to-own agreements has left them open to scams. When getting ready to buy a lease-to-own home, it’s not uncommon for buyers to stumble on any one of these circumstances:
- The property they’re “buying” is in foreclosure
- The owner is behind on property taxes
- The seller doesn’t actually own the property
- The property is in disrepair
- Promised repairs aren’t made after the contract is signed
According to a 2016 report from The New York Times based on the NCLC study cited earlier in this guide, many lease-to-own agreements around the country are actually set up with the intention to fail. Upon completion of many rent-to-own agreements studied by The Times, buyers walked away with nothing, even after spending their own money on rent and repairs for years. Some buyers were faced with surprise evictions on houses that were not up to code, leaving them without a place to live after forking over cash for rent and upkeep. And since lease-to-own housing agreements don’t typically require a home inspection, buyers may be completely unaware of the severity of a property’s condition until they move in.
In terms of pitfalls to watch out for, Davis offers a wide range of scenarios that, although rare, you should probably be aware of before signing a lease-to-own agreement. For example, imagine the seller of the home becomes unable to sell the property to the renter involved in the lease-to-own agreement. Perhaps they default on their mortgage, end up with a tax lien on the property, or get a divorce that results in a messy legal battle. In any of those cases, the property owner may look for ways to get out of the lease-to-own agreement regardless of the consequences for the buyer.
In other cases, the appreciation — or lack of appreciation — a property experiences could cause trouble as well. For example, a property could appreciate in value so much that the seller tries to get out of the agreement by any means necessary. On the flip side, a property may lose value as well, leaving buyers in a position where they’re locked into paying more than the house is worth.
And, what happens if a buyer can’t qualify for a mortgage once their lease-to-own agreement is finished? “If the renter is unable to purchase, they could lose their option money and rent credit — and any legal right to ever buy the property,” says Davis.
Pros and cons of lease-to-own homes
No matter your financial situation, there are plenty of notable pros and cons to consider before signing a lease-to-own agreement. Here are a few benefits and drawbacks that may be applicable.
Benefits of lease-to-own agreements:
- Qualify with poor credit and no down payment. If bad credit (or no credit) has made it impossible for you to qualify for a traditional mortgage, a lease-to-own agreement would let you purchase a home regardless of credit.
- Build equity in a property you hope to buy. While renting a property doesn’t allow you to build equity, lease-to-own agreements allow you to build ownership in a property over time.
- Experiment with a home or neighborhood. Since most lease-to-own agreements offer the option to buy a property after an initial rental period, you’ll have time to try out a home and neighborhood before you decide.
- Lock in a price on a home before taking out a mortgage. If you’re worried about the rising costs of real estate in your area, a lease-to-own contract may make it possible to lock in a price for a property so you can formally purchase it later on.
- Enjoy pride of ownership. When you’re buying a home through a lease-to-own agreement, you get the satisfaction of knowing you may own the property one day.
Drawbacks of lease-to-own agreements:
- Lease-to-own agreements come with fewer consumer protections. The fact that these agreements have less oversight means they are often risky for consumers.
- Watch out for “gotcha” policies. Some lease-to-own agreements end the moment you miss a payment. In those instances, all rent and upfront fees you paid would be forfeit.
- You may need to pay high fees and monthly rates. As the FTC notes, lease-to-own agreements often come with high upfront fees and higher monthly payments than if you rented. Because of these fees, you could easily pay more than you would have if you had used a traditional mortgage.
- You may need to qualify for a mortgage later. In the case of shorter-term lease-to-own agreements, your purchase of the property may be predicated on your ability to get a mortgage in the future. If you can’t qualify for a home loan later on, you may lose all rent and deposits you’ve paid, along with cash paid for repairs and maintenance.
- The price of the home could plummet. If the value of the property you’re buying drops during your lease-to-own agreement, you may wind up paying more than the home is worth.
To avoid these messy situations, renter-buyers should do everything they can to treat a lease-to-own agreement like a real home purchase, Davis says. You should talk to lenders about financing, review their credit report, and have a home appraisal and inspection done before you sign on the dotted line.
“Renter-buyers should also screen the landlord-seller as much as possible to make sure they’re reputable, honest, and financially stable,” Davis adds.
Here are some additional steps to take before you sign a lease-to-own rental agreement, per the NCLC.
Require disclosure of the finance charge and APR. Since lease-to-own agreements aren’t as involved and lengthy as traditional mortgages, it’s easy for sellers to hide or obfuscate the total finance charges involved. That’s why buyers should insist on full disclosure of finance charges to ensure they’re not being overcharged.
Get an appraisal. This is a good reason to get an independent appraisal of the property, notes the NCLC. By finding out how much the home is truly worth, you can find out if your finance charge is fair or if it’s simply hidden in an inflated purchase price.
Require full disclosure of how and when taxes and liens are paid. Sellers should be required to fully disclose all taxes and liens owed on the property, along with when they will be paid. Buyers should insist on such a disclosure. If the buyer plans to cover the costs of taxes or assessments, an agreement should be drawn up.
Make sure the transaction is recorded. The seller should be required to record the contract after it is signed. Buyers should insist their contract is recorded within a fairly short amount of time, usually around 30 days.
Ask for an annual report. Ask the seller to provide an annual report of amounts paid and how all payments were applied.
Ask for an outline of protections for the buyer and seller in case of early default. Consequences for default should be fully outlined in the rental agreement whether the buyer or the seller becomes unable to execute the terms of the agreement.
Meet with a lawyer. Having a real estate attorney look over your lease-to-own agreement is a smart move if you hope to avoid falling victim to details hidden in the fine print. An attorney will be able to tell you if the agreement is fair and if any additional provisions need to be added.
Meet with a mortgage lender. If your lease-to-own agreement requires you to take out a mortgage to purchase the property down the line, it’s important to determine whether that will be possible in the near future. By meeting with a mortgage lender ahead of time, you can find out how your credit fares now and what steps you should take to improve your credit in the interim.
Before you sign a lease-to-own agreement, it’s important to find out everything you can about these contracts and how they work. The following questions and answers may help shed even more light on this issue and whether it’s the right option for you.
Does buying a home with a lease-to-own agreement cost more than purchasing a home with a traditional mortgage?
While the costs of buying real estate vary based on the transaction, most lease-to-own agreements ultimately cost more than buying a home with a traditional mortgage. As the Better Business Bureau notes, landlords typically charge more for a lease-to-own agreement than they would if they were renting the home. Extra charges are sometimes added to the rent or charged as a separate fee, while other times added costs are hidden within the monthly rental cost.
What is a monthly rental credit?
Most lease-to-own agreements have stipulations that state a percentage of each rent payment gets allocated toward equity in the property. This is called the monthly rental credit. This amount can vary widely depending on the terms of the agreement, but it can be as high as 50 percent.
Should I sign a lease-to-own agreement if I have good credit?
Lease-to-own homes are targeted to people who don’t have the credit or a down payment to qualify for a traditional mortgage. Because costs are higher with lease-to-own homes, those who can qualify for a traditional mortgage should pursue that option if they have the choice. There are several low down payment mortgage options available.
What happens if I decide not to buy the property?
Since lease-to-own homes aren’t treated the same as a traditional mortgage, the property won’t fall into foreclosure if you decide not to purchase later on. If you do decide not to purchase the home you are renting through a lease-to-own agreement, you’ll forfeit any rent payments and upfront fees you’ve paid as well as money spent on maintenance and repairs.
What is the best way to improve my credit to buy a home?
If you decide to improve your credit so you can purchase a property outright, there are several ways to make a big impact on your score right away. The best ways to improve your credit quickly include checking your credit report to look for errors, making sure all your bills are paid on time, and reducing the amount of debt you owe.
Do I need an inspection before I sign a lease-to-own agreement?
Getting a third-party home inspection is the best way to find out about costly defects in a home. By hiring a licensed inspector, you can find out about any defects, any repairs or upgrades that need to be made, and the general condition of the home before you move in or agree to buy. If a home has serious problems you don’t want to deal with, you’ll be able to walk away before signing a lease-to-own agreement.
Do I need an appraisal?
An independent appraisal helps buyers find out the fair market value and fair market rent for their property. According to the NCLC, it can also help verify the inspector’s estimate of costs required to make the home habitable. With this information in hand, buyers can determine whether their lease-to-own agreement is fair.
Is a lease-to-own agreement the same as an installment land contract?
While lease-to-own agreements and installment land contracts both help buyers purchase a property from a seller, the way they work in the long term is rather different.
Longer-term agreements allow renters to purchase a property from the seller through an installment land contract. These contracts typically take place when a seller wants to unload their property without any involvement from a realtor, or when they want to make purchasing their home a possibility for someone with poor credit.
In these cases, the buyer may acquire “equitable” or “beneficial” title when the agreement is signed. This term is used to describe a type of preliminary ownership that takes place when a buyer in a lease-to-own agreement occupies the property exclusively, makes tax and mortgage payments, and maintains the property. Once an installment land contract is in place, the buyer will make payments to the property on the loan that go toward both principal and interest payments, along with taxes and insurance. The seller will keep the deed in his or her name until the property is paid off per the agreement. Eventually, a closing is held, and the seller will transfer the deed to the buyer’s name.
The bottom line
While lease-to-own homes make it possible for anyone to purchase a home, there are too many notable downsides to ignore. Not only do these contracts tend to make homeownership costly, but they are often full of fine print and hidden details that may set people up to fail.
If you’re angling to become a homeowner, a lease-to-own agreement could work in your favor if you read the fine print and know exactly what you’re getting into. But, as the FTC notes, your best bet may be taking the longer road to homeownership instead.
Instead of jumping into a lease-to-own contract, “consider saving up your money and working on repairing your credit to buy a house down the road,” says the FTC website.