Buying a home is a monumental task and a massive financial investment. While owning a home is a typical aspect of the American Dream, for people with bad credit, it may be near to impossible. In most home purchases, the seller accepts an offer from the buyer and at the end of the transaction, the title of the home changes hands.
Most buyers use a mortgage to finance their investment, allowing the seller to receive the funds in full while the buyer pays off the loan monthly.
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However, in order to be offered a competitive mortgage, a buyer must have a strong credit score with an impeccable credit report, and a large amount of cash for a down payment (typically 20%).
With these requirements, purchasing a home through a mortgage is nearly impossible for some. In recent years, we have seen the rise of Rent-to-Own arrangements between buyers and sellers. Rent-to-Own agreements are also commonly referred to as “Lease Option Agreements”.
What is Rent-to-Own you may ask? The core definition of it is essentially a payment plan. As an example, let’s say a seller owns a home that can be rented for $2500/month. With a Rent-to-Own plan, a “buyer” would pay $3,200 a month, with $2,500 towards the rent and $700 going as a credit toward purchasing the home.
After 24 months, the $700 difference will add up to a $16,800 credit toward purchasing the home (down payment, closing costs, etc.).
Benefits of Rent to Own
Rent-to-Own agreements can be beneficial to those with credit issues. It also allows the buyers to get a feel for the neighborhood, neighbors, and the general area before making a large commitment, such as a mortgage.
Rent-to-Own agreements also help buyers with poor credit since it allows them 12-36 months to improve their credit score in order to qualify for a more affordable mortgage.
In most Rent-to-Own agreements, the potential buyer will pay the seller a one-time fee. This fee is typically non-refundable and is known as “option money” or “option consideration”. This gives the potential buyer the right, but not the obligation, to purchase the home at the end of the lease. If a buyer simply decides to not purchase the home, the contract simply expires.
Some contracts may contain the words “lease purchase” and exclude the word “option”, which could mean that the potential buyer is obligated to purchase the home at the end of the agreement.
Risks of Rent to Own
However, Rent-to-Own agreements are not without their risks and downfalls. First and foremost, there is little protection for the buyer if he/she defaults on their payment. If you fall behind payments and the landlord evicts you, you will lose any fees and rent premiums you’ve paid.
If you are also unable to obtain an affordable mortgage after the rental period is over, you may have to give up the extra cash you had invested in the home through your rent premium.
Since Rent-to-Own agreements are so varied, especially from a legal standpoint, it is essential to understand what you are signing up for before committing to an agreement. Often times, this form of agreement is set to favor the landlord/seller.
Reading the fine print in the contract is key since some phrases and language can put you at a higher risk of defaulting and losing any additional premium you may have paid.