Rent to own homes can be a great option for bad credit borrowers if you understand how to find a fair deal
Rent to own homes are a favorite tool of landlords and bad credit borrowers alike. 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. 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 use 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 to not 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 certain time and for a certain price.
The landlord and tenant settle on a contract which is signed and notarized so it’s a legal document. 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, and you’ll see this repeated throughout the article is that everything MUST be spelled out in the contract.
If it’s not in the contract, then it’s not going to happen!
The tenant pays rent every month and may also pay a little extra called a “lease credit” which goes to the purchase price of the house. The lease usually runs for five years, at which time, 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 were just renting. They might have to pay for things like 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 tenant has the right to buy, they don’t have to and can walk away from the agreement 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 purchase price at the end of the contract.
Lease Credit – Extra money paid each month beyond rent that gets taken off the purchase price of the home at the end of the contract. Option money and lease credit payments are all lost if you do not buy the home at the end of the contract.
Escrow Account – A bank account that collects payments for taxes, insurance, utilities and repair before they need paid. Some property owners may require it to make sure tenant is keeping up with their responsibilities on the home.
Balloon Payment – The amount to be 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 that was better than just getting a mortgage for the house.
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. The owner knows you don’t have many options so they are going to 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 just 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 then 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 down payment for the next few years. I increased my credit score 200 points in the five years to 760 FICO in 2013, good enough to get any mortgage I wanted.
A rent to own home also gives you the chance to build up equity in the home while you lease. That purchase price is locked in on the contract so if the market value goes up then you’ve got instant equity when you buy it.
One warning here 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 good 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 normally 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 a 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 purchase price of the home 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 payments every month with a little 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 normal mortgage or rent. Understanding how much these extra costs add up to and whether it’s worth it to you 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 into your numbers
The point again 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 just 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 you start 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 as 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 own 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 been considering 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 usually a good way to find rent to buy deals as well.
The final way to find lease option properties, and really 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’re probably going to 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 probably try that route even if you have to wait a while to save up the down payment.
Understand that landlords are going to take advantage of your bad credit and the fact 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 the investment.
There are a few things to remember before signing a rent to own contract.
First is to know the fair price of the home. You’ll have to accept that rent to own homes are going to be more expensive, but you don’t have to accept a huge 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 and 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 actual sales information.
Have a real estate lawyer look over the contract provided by the property owner. This is going to cost a couple hundred dollars and you’ll be tempted to just 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 normal rental headaches and a tenant that is going to 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 that 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 make sure there are no liens on the property.
- Make sure the contract gives you the right to see the owner’s mortgage payment receipts. An owner in trouble might decide to stop paying the mortgage while the tenant keeps paying.
Contracts should allow for a reasonable time you can be late on a payment, usually 10 days, without voiding the contract. Responsibility for repairs should be reasonable also with a certain allowable time and to be inspected by a third party.
Rent to Own Arrangements: Two Types
1) The first kind gives you a chance to get familiar with the home and neighborhood before deciding whether or not it's really what you want. In return for being allowed to live in the house before buying it, you pay a slightly higher rent.
2) The second kind of RTO requires that you make all of your rental payments before ownership is transferred to you. You are required to 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 Really Prepared to Move?
When people move into new homes, they 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 are unable to come up with enough money at once for a down payment, closing costs and other expenses related to the purchase of 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 if you fail to pay for some reason, you could forfeit all of your money and also lose any down payment that may have been made during the deferred contract process. Before signing any agreement, be sure that you are ready for this possibility. In addition to forfeiting your deposit, you might find that collection agencies are called in. This means that your credit will be seriously damaged by an RTO contract violation. If there is a clause in the contract allowing the owner to sell your contract to a third party, you might also find yourself facing legal action and having 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 having to use 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 they should look out for before entering into an agreement with a seller offering Rent to Own contracts. These contracts are not regulated by any government authority, so there is no agency that 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 that aren’t able to get a traditional mortgage. They aren’t the best situation but there are enough benefits that you should consider a lease option if you really 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 leaves 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 fair market value of the home. You can negotiate it lower but accept that it will be higher.
- Having to pay rent plus a lease credit and other home owner costs might leave little room for saving money or even enough to make your 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 a good financial tool for bad credit home owners but there are risks. Understand all the ways landlords try to scam you on lease options and what makes a good deal. Don’t be afraid to negotiate and walk away from a home if you don’t get a fair offer.
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