Rent to own homes can be an excellent option for bad credit borrowers if you understand how to find a fair deal
Rent to own homes are a favorite tool for landlords and bad credit borrowers. So how can it be that both sides of the table like these financial tools so much?
It's because the rent to own option can be the only option for some looking to buy a home, but it can also be an easy way for landlords to squeeze money out of people.
I'm going to be straight-up honest with you. I used to love rent to own homes as a property owner. But, even being fair to the tenant, there's a good chance the owner gets to keep the property while collecting years of higher rent.
There are good reasons to buy a lease option home, though, and it can work great for bad credit borrowers.
I'm going to walk you through everything you need to know before signing a rent to own home contract, how to get the best deal and how not to get screwed.
What is Rent to Own?
Rent to own, also called lease option, is a special contract between a renter and the property owner that gives the renter the right to buy the house at a specific time and for a specific price.
The landlord and tenant settle on a signed and notarized contract, so it's a legal document. Next, the renter usually puts down what's called option money which is like a down payment. This option money is usually around 5%, with all or some of it taken off the purchase price.
One of the most important things to remember with a lease option, rent to own home, which is repeated throughout the article, is that everything MUST be spelled out in the contract.
If it's not in the contract, then it will not happen!
The tenant pays rent monthly and may also pay a little extra called a “lease credit” which goes to the house's purchase price. The lease usually runs for five years, when the renter has to get a loan to pay off the rest of the house.
While the renter is under the lease option, they may be responsible for more than usual if they had a standard lease. For example, they might have to pay property taxes, utilities, repairs, and insurance.
Some important rent to own home terms you should remember:
Lease Option – The right of the tenant to buy the house for a certain price and other terms. Also called Rent to Buy agreements. While the tenant has the right to buy, they don't have to and can walk away from the contract at any time.
Option Money – Money paid upfront for the lease option contract. Usually between 2% to 7% of the purchase price, and some may be taken off the purchase price at the end of the contract.
Lease Credit – Extra money paid each month beyond rent that gets taken off the home's purchase price at the end of the contract. Option money and lease credit payments are all lost if you do not buy the house at the end of the contract.
Escrow Account – A bank account that collects payments for taxes, insurance, utilities, and repair before they need to be paid. Some property owners may require it to ensure the tenant is keeping up with their responsibilities in the home.
Balloon Payment – The amount paid on the home at the end of the contract. This is the purchase price minus the option money or any lease credits taken off. This is the amount you need to be able to get a loan for, usually in five years.
Is Rent to Own Better than a Mortgage?
Rent to own homes can be a good deal for buyers, but I've rarely seen a lease option better than just getting a mortgage.
The biggest problem with rent to own homes, and we'll cover quite a few, is that the price is usually more than market value. However, the owner knows you don't have many options, so they will get a little more than they normally would otherwise.
But saying a lease option is always worse than a mortgage isn't fair either…because sometimes a mortgage isn't an option.
Banks have started lending again after the financial recession but not to everyone. If your credit score is below 650 FICO, you're not getting a loan from a traditional bank or credit union.
Even if you have a good credit score, you might not be able to get a mortgage if you don't have the 20% down payment some loan programs require.
That means a rent to own program might be the best option available, your only option.
Buying a rent-to-own home can give you the time to build your credit score and make a down payment for the next few years. I increased my credit score 200 points in five years to 760 FICO in 2013, good enough to get any mortgage I wanted.
A rent to own home also allows you to build up equity in the house while you lease. That purchase price is locked in on the contract, so if the market value goes up, you've got instant equity when you buy it.
One warning is that owners may try to sneak in an annual price increase on the purchase price or put it so high on the contract that even strong market value appreciation might not help much. We'll talk later about making sure you get a reasonable price.
The downside to a lease option home is the additional costs, higher price, and the chance you won't be able to get a loan when the contract expires.
I usually recommend a few points to buyers considering a buy to rent home:
- Your credit score should be at least 600 FICO, so you can reasonably expect to build it to 700 by the end of the contract. That means making all payments on time during that time and building a good credit history so you can get a loan.
- Don't get into a lease option if you are within a year or two of bankruptcy. That might not give you enough time to improve your credit for a loan, and the bankruptcy will still be on your credit report in five years.
- Don't sign a buy to rent contract if the home's purchase price is more than 20% over the fair market value.
- Add up all monthly payments for rent, lease credits, and all other responsibilities. Don't sign a buy to rent contract if you're not 100% sure you can make monthly payments with some money left to spare for an emergency fund.
How Much Does it Cost to Rent to Own a House?
Buying a rent to own home comes with extra costs beyond a standard mortgage or rent. Understanding how much these additional costs add up to and whether it's worth it will help you make the decision.
- Start with finding how much higher the lease option price is above market value.
- Compare monthly payments on a regular mortgage for the amount against what you're expected to pay in rent and the lease credit
- If the owner is charging any interest on the contract or an annual increase in the purchase price, add that to your numbers
The point is that you have to ask, and everything needs to be spelled out in the contract. The landlord can change anything not defined in the contract.
If the costs of a buy to own home are too high, you might decide it would be better to pay rent for a couple of years, save up for a down payment and buy when you can. Even with bad credit, you can usually improve your credit score enough to qualify for a loan in a few years.
If you're struggling to find the down payment for a traditional mortgage, you might try borrowing on a peer-to-peer loan. Since the loan isn't securitized, you don't need a house to use as collateral. You can borrow up to $35,000 for a down payment and use it to qualify for a mortgage or FHA loan.
How to Find Lease Purchase Homes
Before looking for lease option homes, try one last time to get pre-approved for a mortgage or loan program. FHA mortgage loans require only 3.5% down and can approve many borrowers with bad credit, as low as 600 FICO.
If you have no other option, there are a few ways to find buy to rent homes.
Look for homes for sale on the real estate platforms like Zillow, Trulia and Realtor. These sites will have some homes listed with the buy to rent option, but you can also approach traditional sellers.
If a home has been on the market for more than a few months, the seller might be desperate enough to offer you a deal on a lease option. It might not be possible if they need to pay off their mortgage on the property, but it's worth asking.
This method is usually the best because sellers aren't experienced landlords looking to screw over rent to buy tenants. You usually won't have to pay much of a premium on the house price, and terms will be fair.
Another option is to ask owners of rental properties for a lease option. They may not have considered it before, but as they say, everything is for sale for the right price. Make sure you're not paying too high a price for the home, but this is an excellent way to find rent and buy deals.
The final way to find lease option properties, and the worst way, is to use rent to own websites or the newspaper for properties specifically marketed as rent to own. Websites like housinglist.com and irenttoown.com charge up to $99 a month to browse properties. Since the homes are being sold specifically as rent to own, they'll probably be much more expensive than you'll find with the other methods.
How Does Rent to Own Work with Bad Credit?
Rent to own ONLY works with bad credit. If you have any other option and can get a bad credit mortgage, you should try that route, even if you have to wait a while to save up the down payment.
Understand that landlords will take advantage of your bad credit and that you don't have any other option. It's not entirely unfair. They are taking a risk that you won't take care of the house or that property prices will jump, and they'll be out of the investment.
There are a few things to remember before signing a rent to own contract.
The first is to know the fair price of the home. You'll have to accept that rent to own homes will be more expensive, but you don't have to accept a significant premium on the market value.
- Look at other homes for sale in the neighborhood and divide the sales price by square footage.
- This is your price per square foot; the average will tell the market value of your home.
- You can ask a real estate agent or look to the county assessor page for sales information.
Have a real estate lawyer look over the contract provided by the property owner. This will cost a couple of hundred dollars, and you'll be tempted to look it over yourself. Is it worth losing thousands and the house because the landlord snuck something into the contract to screw you over?
Avoiding Rent to Own Scams
Landlords love rent to own contracts. They get a price above market value and a tenant, none of the usual rental headaches, and a tenant that will take care of the home like it's their own.
That should be enough, but many owners will get greedy and try to cheat rent to own buyers.
Besides making the purchase price way over market value, there are a few common lease option scams for which you should watch out.
- Contracts make it easy for the owner to void the deal or evict the tenant. This might be something like if the tenant is one day late on any payment or doesn't make repairs a certain way.
- Get a condition of title report to ensure no liens on the property.
- Ensure the contract allows you to see the owner's mortgage payment receipts. For example, an owner in trouble might decide to stop paying the mortgage while the tenant keeps paying.
Contracts should allow for a reasonable time to be late on a payment, usually 10 days, without voiding the contract. Responsibility for repairs should also be reasonable within a specific allowable time and be inspected by a third party.
Rent to Own Arrangements: Two Types
1) The first kind allows you to get familiar with the home and neighborhood before deciding whether or not it's really what you want. Then, you pay a slightly higher rent to be allowed to live in the house before buying it.
2) The second kind of RTO requires you to make all your rental payments before ownership is transferred to you. You must put down a down payment when you sign the agreement and then make regular monthly payments until the balance has been paid off. These agreements are known as delayed financing or deferred-payment contracts.
Are You Prepared to Move?
People who move into new homes frequently have problems paying their bills on time. This makes sense because moving always seems to cause financial disruptions in your life, no matter what you do to prepare for it. If you cannot come up with enough money at once for a down payment, closing costs, and other expenses related to purchasing a new home, it's easy to see how moving can become a financial burden.
What Happens if You Don't Make Your Payments?
If you don't make your rental payments on time or fail to pay for some reason, you could forfeit all of your money and lose any down payment that may have been made during the deferred contract process. Before signing any agreement, be sure you are ready for this possibility. In addition to forfeiting your deposit, you might find that collection agencies are called in. An RTO contract violation will seriously damage your credit. If a clause in the contract allows the owner to sell your contract to a third party, you might also face legal action and have another person's name on the mortgage.
RTO contracts allow renters who can't afford to make large down payments or closing costs to become homeowners. You can pay as you go and own your home in a few years. It might also be possible to buy sooner if you can qualify for a mortgage loan on your own without using the RTO contract as backup financing, eliminating the risk of losing money and damaging your credit.
What You Need to Know Before Signing Any Contract
Many renters don't know what to look out for before agreeing with a seller offering Rent to Own contracts. Any government authority does not regulate these contracts, so no agency ensures that interested parties have been fully informed about risks or terms. If you come across such an offer, never agree to anything until you've read every word of the contract.
Should You Rent vs. Buy Your Home: Pros and Cons
Rent to buy programs can be a great financial tool for bad credit borrowers who can't get a traditional mortgage. Of course, they aren't the best situation, but there are enough benefits to consider a lease option if you want to own a home.
Pros of Rent to Own Homes
- The price of the home is locked in, giving you the potential for instant equity if real estate values increase.
- Five years is a long time to improve your credit score and usually enough to qualify for a mortgage if you're on time with payments.
- If the rent and lease credit amount leave room in your budget, you can use the time to save up a sizeable down payment.
- Rent to own might be the only option available to bad credit borrowers
Cons of Rent to Own Homes
- The purchase price is usually well above the home's fair market value. You can negotiate it lower but accept that it will be higher.
- Having to pay rent plus a lease credit and other homeowner costs might leave little room for saving money or even enough to make monthly payments.
- The balloon payment at the end of the contract can easily be a couple hundred thousand and impossible to cover without a loan.
Rent to own homes can be an excellent financial tool for bad credit homeowners but there are risks. Understand how landlords try to scam you on lease options and what makes a good deal. Don't be afraid to negotiate and walk away from home if you don't get a fair offer.
Read the Entire Investing in Real Estate Series
- Real Estate Investing vs. Stocks: Pros and Cons
- How to Find Commercial Real Estate Investors?
- Reasons Why Now is the Best Time to Invest in Real Estate
- The Great 2021 Real Estate Reset and the Only Properties I'm Buying
- Fundrise Review: How It Boosts Your Real Estate Investing Opportunities