According to a recent study by Harvard University, roughly a quarter of the residents in San Francisco and Los Angeles can afford the purchase price of a median-priced house in those locations. There are millions of American citizens who simply cannot afford to purchase the homes they're living in. This number keeps on going up too. The rate of homeownership has decreased because the millennial generation is more interested in renting and not having to deal with a mortgage.
Millennials do not purchase homes because they constantly must worry about their monthly rent payments. The transition from renting to buying a home is nearly impossible for them. But what if the rental payments could be used to help buy these homes in the future? Imagine renting a place on a lease agreement and then being able to purchase the place once the lease expires? You can do this with something called a rent-to-own agreement.
The Basics of a Rent-to-Own Agreement
Although Rent-to-Own agreements are not as common, they can be quite beneficial to a renter who desperately wants to be a homeowner. For one thing, there is no big down payment required. Your rent payments are basically like the down payment. This agreement is a much better alternative to home-buying assistance programs.
Once your lease expires, a Rent-to-Own agreement will give you the right to purchase the property. This agreement is formed between the landlord and the renter before the lease is signed. The term of the lease is typically anywhere from 1 to 3 years. As a tenant, you must make your monthly rent payments during this time. The details of the agreement will specify the purchase price to be paid once the lease expires.
Rent-to-Own Agreements have premium payments which are similar to down payments, except that premium payments are much smaller amounts than down payments.
A Rent-to-Own agreement won't require you to purchase the property after the lease ends. However, the initial money that you paid does not get refunded if you decide to walk away after the lease is over.
You and the property owner will need to negotiate the amount of the initial payment. No set price exists for this type of payment. In most cases, the initial payment will be anywhere from 3% to 7% of the purchase price. A lot of negotiations will just settle at 3%.
Sometimes the agreement terms will let you apply the initial payment to the purchase price. This gets negotiated before anything is signed since certain agreements might have different terms.
Advantages and Disadvantages of Lease Option Agreements
Make a Smaller Upfront Payment
The typical down payment to purchase a home is 20%. This means if you purchase a $200,000 home, the down payment will be $40,000. But with a lease option agreement, it would only be $14,000. As you can see, this is a much better price.
Apply Rent Payments to Home Purchase Price
Most contracts will allow every monthly payment for your rent to be deducted from the purchase price. This is basically "rent credit", but it is not suitable for everybody.
You see, if rent credit reduces your purchase price, then it means you'll have bigger monthly payments to make. But you'll still be making a down payment with your rent payments, so the owner will need to take their property off the market.
Figure Out the Purchase Price Ahead of Time
The lease option agreement needs to outline how the purchase price will be determined between you and the owner.
Most people will want to maintain a fixed price because they're hoping their property's market value will increase over time. But if you decide to have a fixed price, the property owner may factor that into the deal too. They know the real estate market gradually goes up, so they don't want to lose out completely.
Losing the Initial Payment
The lease option agreement gives you the choice to purchase the property once the term expires. But if you don't like the property and wish not to purchase it, you have the freedom to walk away. The only downside here is that you will forfeit the money you paid so far. Remember that your payments were not a security deposit, so you cannot get them back.
House Maintenance Responsibility
A property owner will typically place the responsibility of home maintenance on the tenant's shoulders. In their eyes, the tenant is going to be purchasing their home in a couple of years anyway. So, the tenant should be the one to maintain the property in the meantime. Therefore, things like general maintenance jobs, renovations, and decorations will fall upon you (the tenant).
In the agreement, make sure that all the details regarding the responsibility of the maintenance are specified in there. It should outline who is responsible for every menial task, such as raking leaves, mowing the lawn, shoveling snow, and so on. In addition, make sure it is clear who pays the taxes and association fees on the property. The owner may try to get you to pay for these things.
Deciding to Walk Away
You are not required to purchase the property after the lease is expired, as long as the agreement states that you can do that.
With a lease-option agreement, you have an easy option to just walk away from purchasing the property after the lease expires. You have no further obligations after that. However, with a lease-purchase agreement, you may be required to purchase the property after the lease is finished. It all depends on the specific wording in the agreement, so pay attention to it.
A Rent-to-Own agreement can be beneficial, depending on your current financial situation. If you have bad credit, then it is a great opportunity.
Even if your debt to income ratio is not so great, your budget may be large enough for you to pay more money upfront. A rent-to-own lease can be signed which eliminates the need for a down payment.
Be aware that there is a 50% chance you will walk away from the property and not buy it. This means you won't get back your initial payment. On the other hand, if you're a self-employed person with hardly any track record, the risk is worth it.