Rent-to-own

Rent-to-own, alternately known as rental-purchase or purchase-option financing, is a financing option in which a renter-buyer acquires an item by leasing it but has an option to purchase the item in the future, as indicated in the lease agreement. While rent-to-own financing is often applied to major household and personal purchases such as home electronics, furniture, appliances, and vehicles, it can also be used in real estate.

Rent-to-own arrangements offer renter-buyers specific advantages, but they come with costs that do not apply to traditional rental or purchase agreements. There are also additional drawbacks and potential pitfalls that renter-buyers should carefully consider before entering into such an agreement, particularly in the case of rent-to-own real estate purchases.

Background

In most cases, buyers do not cover the total cost of a major purchase upfront but instead, opt to finance the purchase and gradually pay off the cost of the item on a weekly, bi-weekly, monthly, or quarterly schedule. Depending on the value of the item and the seller's requirements, the buyer may also have to make a down payment on the item, which is usually a set percentage of its total purchase price. For example, in the case of real estate, home buyers typically have to make a down payment of at least 5 percent of the property's agreed-upon purchase price and secure additional financing from a bank or mortgage lender to cover the remainder of its cost.

However, these financing arrangements may not be available to some buyers. Low credit scores or a lack of credit history can prevent would-be buyers from qualifying for financing. In the case of automobiles and real estate, the buyer may also lack the capital to make the required down payment.

Before the advent of rent-to-own financing, buyers in such situations usually had no option but to rent the item rather than purchase it. While renting has some advantages, it is generally considered better to purchase a major item, as it allows the buyer to enjoy the advantages of ownership, including the ability to resell the item at a future date. Rent-to-own financing bridges this gap. It allows people with low credit scores, a lack of credit history, or a lack of money for a down payment to acquire a desired item through a lease or rental arrangement. They can then purchase the item at an agreed-upon price at a later date.

Specific to real estate, rent-to-own financing offers benefits for both renter-buyers as well as owner-sellers. Renter-buyers can use rent-to-own agreements to overcome obstacles preventing them from qualifying for homeownership, and owner-sellers open themselves up to a larger pool of prospective buyers while reducing some of the risks traditionally associated with property rentals. In real estate, rent-to-own agreements are usually referred to as rental-purchase or purchase-option financing.

Overview

Regardless of the item they are used to finance, rent-to-own agreements typically contain several common elements. The duration of the contract is specified; this is the length of the rental period. If the renter-buyer does not purchase the item before the expiration of the contract, possession rights to the item revert to the owner-seller. The owner-seller continues to own the item for the duration of the rental or lease agreement unless the renter-buyer exercises their right to purchase the item.

In addition to the weekly, bi-weekly, monthly, or quarterly rental price, a purchase price for the item is also specified. The purchase price may reflect fair market value for the item when the rent-to-own agreement commenced, or it may contain an added premium. Rental payments are typically not applied toward the eventual purchase of the item unless the renter-buyer and owner-seller specifically agree to enter into such an arrangement. In such cases, it is common for a set percentage of the rental payments to be applied toward the future purchase of the item. Alternately, renter-buyers and owner-sellers can agree to set up two different payment schedules, with one payment schedule covering rental costs and the other covering contributions toward an eventual down payment.

Purchase-option agreements also typically contain a fee charged by the owner-seller as consideration for entering into the rent-to-own arrangement. In real estate, this fee is usually in the range of 2 to 3 percent of the purchase price, though renter-buyers and owner-sellers can negotiate alternate rates that both parties find equitable. If the renter-buyer decides to exercise their option to purchase the item at the specified price, they notify the seller-owner, arrange purchase financing, and come into formal ownership of the item.

For renter-buyers, a key advantage of rent-to-own financing is that they allow the renter-buyer to submit the necessary down payment over time rather than all at once. This enables renter-buyers who lack down-payment capital to secure an item at an acceptable price and then generate the down payment over an extended period, thus reducing the financial strain that can come with committing a significant sum of money to a major purchase. Specific to real estate, purchase-option financing can also generate instant profits for the renter-buyer if the home experiences significant appreciation during the rental period. For example, a renter-buyer and an owner-seller may agree on a $300,000 purchase price for a home, with the renter-buyer exercising their option to buy the home one year later. If the value of the home has appreciated by 10 percent over the course of that year, the renter-buyer will acquire a property valued at $330,000 for the original $300,000 price. Owner-sellers also tend to prefer to rent real estate to renter-buyers rather than traditional renters, as renter-buyers are considered more likely to take better care of the property if they plan to purchase it in the future. A further potential benefit for renter-buyers could be an improvement in their credit score.

However, renter-buyers expose themselves to some risk by entering into rent-to-own or purchase-option financing arrangements, especially with regard to real estate. First, the renter-buyer may not be able to secure mortgage financing, even if they wish to purchase the home. In such a situation, ownership of the home would revert to the owner-seller. In addition, the renter-buyer will lose the option consideration fee paid to the owner on signing the contract if they do not complete the purchase of the house, which can add up to a considerable amount of money. Using a $300,000 home and a 2-percent option consideration fee as an example, the renter-buyer would forfeit $6,000 if they did not exercise the purchase option. Finally, just as a home may appreciate during the rental period, is also may depreciate, leaving the renter obligated to purchase at above market value.

Bibliography

Claflin, Katie. "The Pros and Cons of Rent-to-Own." Texas State Affordable Housing Corporation, 5 Dec. 2014, www.tsahc.org/blog/post/the-pros-and-cons-of-rent-to-own. Accessed 14 Nov. 2024.

Dodge, Amanda. “Why Rent-to-Own is Bad for Buyers and What to Do Instead.” FastExpert, 18 Jan. 2024, www.fastexpert.com/blog/why-rent-to-own-is-bad. Accessed 14 Nov. 2024.

Durkin, Thomas A., et al. Consumer Credit and the American Economy. Oxford University Press, 2014.

Folger, Jean, et al. "Rent-to-Own Homes: How the Process Works." Investopedia, 9 Oct. 2024, www.investopedia.com/articles/personal-finance/100714/renttoown-homes-how-process-works.asp. Accessed 14 Nov. 2024.

Friedburg, Barbara. Personal Finance: An Encyclopedia of Modern Money Management.ABC-CLIO, 2015, pp. 195–198.

O'Connell, Ann. “The Basics of Rent-to-Own Agreements.” Nolo, 22 June 2023, www.nolo.com/legal-encyclopedia/the-basics-rent-own-agreements.html. Accessed 14 Nov. 2024.

Petry, Michele, et al. "Renting vs. Buying a House: Which is Right for You?" Bankrate, 29 Mar. 2024, www.bankrate.com/finance/mortgages/rent-to-own-when-it-s-not-time-to-buy-1.aspx. Accessed 14 Nov. 2024.

Pritchard, Justin, et al. "What Is Rent-to-Own?" The Balance, 24 June 2022, www.thebalance.com/what-is-rent-to-own-315664. Accessed 14 Nov. 2024.

Weisleder, Mark. "Rent-to-Own Works, But Beware the Pitfalls" Toronto Star, 30 July 2013, www.thestar.com/business/personal‗finance/2013/07/30/renttoown‗works‗but‗beware‗the‗pitfalls.html. Accessed 14 Dec. 2016.

Woodward, Emma, et al. “20% of Aspiring Homeowners Think They’ll Never Save Enough to Buy. Can Rent-to-Own Help?” Bankrate, 3 Apr. 2024, www.bankrate.com/real-estate/how-rent-to-own-works. Accessed 14 Nov. 2024.