The Basics of Rent-to-Own Agreements

Learn whether a lease-to-own or lease-option agreement is a good choice for tenants who want to buy the home they rent.

Rent-to-own agreements, also called lease-to-own agreements or lease-options, are traditional leases agreements that also give the tenant an option to purchase the rental property, typically a single-family house. Whether you are a landlord or a tenant living in a single-family property, the arrangement has potential financial and other benefits, such as:

  • a reasonably priced home for a tenant who might not easily qualify for a mortgage, and
  • some certainty about a potential sale for the landlord, without having to market the property and hire a real estate agent.

This article will discuss these benefits, as well as downsides to watch for and legal details to attend to.

Components of the Rent-to-Own Agreement

A rent-to-own agreement is actually made up of two agreements:

  • a standard lease agreement, and
  • an option to purchase.

These may be incorporated into one document or prepared and signed as two separate documents.

What's in the Lease or Rental Agreement

In a rent-to-own agreement, the title to the house remains with the landlord until the tenant exercises the option and purchases the property. In other words, the starting point of this kind of an arrangement is a regular tenancy, not a house purchase transaction.

That means the underlying 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. For more details about common clauses see, Ten Terms to Include in Your Lease or Rental Agreement.

What's in the Option to Purchase Document

An option to purchase grants the tenant an option (right) to buy the rental property within a specified period of time 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).

What happens if a tenant ultimately does not exercise the option to purchase? The landlord will be happy to hear that the tenant 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 in this arrangement, 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 detail about these key issues, see, Key Terms in Option-to-Purchase Agreements.

Obligations of Tenants and Landlords Under a Rent-to-Own Agreement

Here are a few ways that lease agreements with a lease-option component vary from traditional leases.

Rental Payment Arrangement Varies

Just as in a standard lease or rental agreement, the tenant with a rent-to-own arrangement has a duty to make timely and exact payments of rent. However, in a rent-to-own arrangement, rent payments are often set higher than they would have been had the transaction been a standard lease agreement.

This is because an agreed-upon percentage of the monthly rent is typically placed into an escrow account, so that it builds up toward the purchase amount.

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 applies a percentage of the rent payments toward the principle of the house. In this manner, the tenant builds equity in the house throughout the duration of the lease agreement.

Tenant Makes Necessary Repairs to the Rental Property

Unlike with a traditional lease, in which the landlord is typically responsible for making all repairs, rent-to-own tenants usually repair 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. The tenant has an incentive to keep it in good repair; and can also customize it to personal tastes, without worrying about the landlord objecting to purple walls, for example. The tenant could even put in higher-quality materials than the landlord is likely to spring for (though this is unlikely in a situation where the tenant is busily saving up to buy the entire house).

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.

This means that the tenant must not keep pets if the lease prohibits them, 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 also 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. Any repairs or improvements the tenant has made to the house will likely not be reimbursed by the landlord.

Before Signing Onto the Option, Tenant Should Inspect the House and Order an Appraisal

Although the tenant might 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 purchase. 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 professional 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 also disclose important information about the condition of the property. Check your state law on required real estate disclosures.

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 could 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 can benefit from a rent-to-own arrangement as well. Landlords who want to sell their rental property, but are having difficulty doing so, might 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 might have various financial incentives for considering a rent-to-own agreement. For example, a landlord with a negative cash flow could 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 sale of the property.

On the other hand, rent-to-own agreements have some possible 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 can 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.

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