Rent-to-own agreements can offer a unique path for buyers looking to get their foot in the real estate market without purchasing right away; however, as with any contract, there are pros and cons to consider.
What are they and how do they work?
“A rent-to-own agreement is both a lease agreement and a promise to purchase. The future ‘tenant’ will have the possibility to purchase the property on a predetermined date at a predetermined price,” says Mark-André Martel, a REALTOR® and broker in Quebec.
Also known as a lease-to-own agreement, rent-to-own agreements are an alternative financial agreement to a traditional mortgage. A contract is signed by tenants and a landlord, or tenants and a rent-to-own company. This agreement enables tenants to rent the home they intend to purchase, while a percentage of each rent payment, which is known as a rent credit, is counted toward the eventual down payment.
A regular misconception is the full amount of rent paid each month is applied to the future down payment, or that it’s contributing to the payment of the property, but this is inaccurate. A portion of the monthly rent is a “rent credit” and in most cases, rent-to-own agreements will require the buyer to have the cash to cover the rest of the down payment, as well as qualify for a mortgage as a means to buy the house when the lease ends.
“Rent-to-own agreements can happen for almost all types of properties,” says Martel, “except undivided co-ownerships. The lease amount can be at market price for leasing that type of property or more, all depending on what’s agreed on.”
There are typically two types of agreements:
• Lease-purchase agreement As implied by the name and on the basis of qualifying for a mortgage, buyers entering into this type of contract will sign an agreement to purchase the home at the end of the lease or rental term. If, for whatever reason, the buyer changes their mind about wanting to purchase, or does not qualify for a mortgage, they risk losing their deposit and rent credits and could potentially face legal action, as well as incur additional charges.
• Lease-option agreement This type of agreement gives buyers the option to purchase the home at an agreed future date, but there’s no obligation to do so if plans change. All rent credits will be lost if, at the end of the lease, the potential buyer no longer wants to purchase the home. In this instance, as per the terms of the agreement, they will not face any other subsequent fines, penalties, or legal action.
What are the pros and cons?
The decision to sell a home through a rent-to-own agreement is ultimately up to the seller, though there are many companies that specialize in rent-to-own properties. Buyers will generally need to have steady employment to qualify for a rent-to-own agreement.
Below are some of the key pros and cons buyers should consider before signing on the dotted line.
Buyer pros:
• Rent-to-own agreements are an attractive option for buyers who don’t yet have enough saved for a large down payment, but expect to build up their savings throughout the duration of the contract.
• Rent-to-own agreements delay the hurdle of a hefty down payment by putting rent credits towards the eventual purchase price.
• Purchase prices can be locked in, which is particularly advantageous if house prices rise in the future.
• Making rent payments on time helps boost credit scores — an essential component for securing a mortgage.
• Buyers get to move into their home and “try before they buy,” even if they can’t yet afford it.
“Aside from a portion of the money spent on rent going towards the purchase, tenants can get an idea of what they might not be able to see,” adds Martel. “Similarly, when a tenant is in their dream home, knowing what they have to do to qualify for a mortgage and make the home theirs is made clear. It’s always easier to attain a goal if you have one in the first place.”
Buyer cons:
• Buyers/tenants are typically responsible for the maintenance of the property, as opposed to the average rental where this could fall under a landlord’s responsibilities.
• Rent-to-own payments are typically higher than mortgage rates.
• There’s a significant amount of money to be lost, with the added risk of penalties and legal consequences, if the terms of the agreement aren’t met.
• If buyers don’t purchase the home, more money may have been saved through paying regular rent.
• There’s potential for a locked-in purchase price to backfire if prices drop in the future.
• It’s possible that once all costs, including elevated rent and deposit fees, are factored in, buyers/tenants may end up paying more than the home is worth in the current market.
Martel adds, “it’s not uncommon for tenants to pay rent above the market price for the space. They ultimately risk paying more than they would have otherwise done on a purchase. It’s also possible when it comes to purchasing, the buyer might overpay for a property or may not have done the proper due diligence.”
Seller pros
• Sellers will have a tenant for an extended period, which means steady revenue for what’s typically 2-3 years.
• Maintenance and repair fees are typically handled by the tenant.
• Sellers are entering a low-risk venture because even in the event of a tenant not buying, they’ve earned their initial deposit and rent.
• New buyers/tenants will be available if things don’t work out with the initial agreement.
Seller cons
• The vetting process for a good tenant delays sellers from going straight to market.
• Tenants can terminate the lease-option agreement at any time.
• Locking in a price could prove disadvantageous if house prices rise in the future.
• Sellers still have to make mortgage payments and the rent may not cover this.
Martel indicates using a REALTOR® is key for rent-to-own agreements. “A REALTOR® has the expertise to guide the seller through a smooth transaction.”
The bottom line
As the traditional route to homeownership remains challenging for many, entering into a rent-to-own agreement can be a lifeline for determined home buyers, and presents several advantages for the seller.
As with any real estate transaction, it’s important to have an in-depth understanding of any prerequisites, to assess the associated risks and to ensure the terms support the desired outcome. Using a REALTOR® can help ensure you’re making informed decisions, and that no step of the process is missed.
The article above is for information purposes and is not financial or legal advice or a substitute for financial or legal counsel.
— Realtor.ca