What is a rent to own or lease option and how does it work?

What is a rent-to-own or lease-option home?

A home purchase with a lease option (also “rent-to-own” or “rent-to-own”) is a lease agreement combined with an option agreement to pay for the home within a stipulated time, usually three years or less, at an agreed cost. Borrower pays an option fee, 1% to 5% of cost, which is credited to the purchase value. Borrower pays a monthly rent and an additional rental payment which is also credited at the purchase price If the purchase option is not exercised, the buyer loses both the non-refundable option fee and the rental premiums paid.

As with any type of money contract, rent-to-own offers can be arranged in such a way that all reimbursement flows to one party and nothing to the other. Buyers especially should be vigilant. But the rent-to-own strategy has strong tax rationale, which means it can be arranged so that both parties benefit.

Characteristics of the contract of a rent with option to buy

A rent to own has 6 main needs. The sale price of the home and the rent are determined by the market, but are subject to commitments just like in a direct purchase transaction or a rental transaction. Buyers often know less about the market than sellers, which puts buyers at a weakness unless they do a little research, which is tricky.

Buyers generally like a long option period better as it gives them more time to build equity and repair credit. An extended period can affect them, however, if they can never put the option into effect, they lose the rental payment they have been paying the entire time, in addition to the non-refundable option fee. Sellers generally like a short option period better, but not too short, or they will never buy the home.

Buyers and sellers view the option fee and rent payment in different ways. For the tenant / buyer, they are the equity of the home they will soon buy. Fully anticipating that they will exercise the option, the only cost is the interest that they would have otherwise earned. For sellers, on the other hand, these payments are the biggest promise that their properties will sell. If they don’t sell, the payments are withheld as earnings. The advantage to the seller commonly exceeds the cost to the buyer, making the lease option transaction a viable win-win.

Using a rent-to-own agreement to buy

Rent-to-own offers favorable terms for home ownership to consumers who cannot qualify for credit from any source, but are willing to gamble for themselves. The gamble is that before the lease-to-own period expires, they’ll qualify for the financing they require to put the purchase option into effect. During the rent-to-own period, they have the opportunity to rebuild their credit and build equity while living in the home.

Consumers who need to rebuild their credit rating for the lease term should understand that paying rent on time will not do so. Tenant’s rent payments are not used to compile your credit score. Fair Isaac, the company that developed the credit score, recently submitted an “expansion” score based on non-traditional credit data, which does not yet include rental payment information for individual tenants. Rent-to-own buyers who need an improved credit score should highlight their credit cards, loans, and other bad debts.

The right not to exercise the option has value to buyers, even if it is costly. You may find that something is seriously wrong with your home, neighborhood, or even neighbors. The money left on the table with a rent-to-own is often much less important than the cost of a direct purchase followed by a quick sale.