Rent-to-own leases provide the opportunity to build equity in a home before you ever purchase it. This is especially helpful if you have bad credit because it allows time to rebuild your credit score, or if you have trouble saving up for a sizable down payment. In these typically one- or two-year leases, you purchase the option to buy the home at a later date and have a portion of rents paid applied toward the purchase price.
A purchase option is an agreement between the lessor (current owner) and the lessee (the renter) that allows the lessee to purchase the home at the end of the lease for an agreed upon amount. This option usually costs between 2.5 to 7 percent of the purchase price and is applied to the purchase price at the end of the lease. As an example, a $200,000 home with a 3 percent purchase option fee costs $6,000 upfront ($200,000 x 0.03) and is not refundable even if you don't exercise the buy option at the end of the lease. This final purchase price might be determined by a current appraisal figure, projected to include appreciation during the lease term, or simply be a subjective figure to which both parties agree.
The lesser cannot renegotiate the purchase price at the end of the lease, even if the appraised value far exceeds the agreed upon amount. That means you could use a rent-to-own lease to see how economic and other factors affect the home's value before committing to a purchase. If the value rises, you might want to buy the house. But if its value tanks or your financial situation worsens, simply walk away. Just keep in mind that doing so forfeits the purchase option payment and any accumulated rent credits.
Because you're entering a contract to optionally purchase the home, the home's maintenance is generally your responsibility.
As part of the purchase option, the lessor agrees to apply some percentage of the rent toward the purchase price. As an example, a lease might stipulate that 50 percent of each $1,000 rent payment be credited toward the purchase, so each month you effectively accumulate $500 in equity. Over the course of a two-year lease, you could gain $12,000 ($500 x 24 months) in equity to defray a portion of the purchase price. Although the rental rate can be whatever the you and the lessor agree to, the rent should still be a fair market rate that is not affected by the purchase option.
To get an idea of the fair market rate, compare rental prices for similar homes in the same area.
Rent credits are applied only if the rent payment is on time. Even if the payment is only one day late, you forfeit that month's credit. To avoid losing credits, always pay on or before the rent payment is due, as stipulated by the lease agreement.
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Suppose you have a two-year, purchase-option lease with 50 percent of $1,000 rents credited toward the purchase price of $200,000. The purchase option cost 3 percent of the purchase price, and you paid your rents on time except for two months:
- Purchase Option: $200,000 times the 0.03 option equals a $6,000 upfront payment.
- Rent Credits: 22 on-time payments times the 0.50 credit application equals 11, and this figure multiplied by $1,000 rent equals $11,000 in rental credits. Note that the two late payments are not included in the rent credits.
- Total Purchase Credits: $6,000 upfront payment plus $11,000 in rental credits equals a total credit of $17,000.
- Final Purchase Expense: The $200,000 purchase price minus $17,000 in credits equals a purchase expense of $183,000. This $17,000 is the equivalent of having an 8.5 percent down payment on a $200,000 home.