What do we mean by Rent-to-Own?
Rent-to-Own is similar to traditional rentals where the tenant rents out the home they're living in. The one major difference is that now, the tenant has the exclusive right to purchase the home from the owner at the end of their rental term.
Rent-to-Own begins with the contract (or lease option agreement). The tenant-buyer and the owner will then negotiate over the terms of the contract. Everything is negotiable from the price of the home at time of purchase, the option premium, to the length of the rental term.
The Rent-to-Own transaction begins with the initial option premium. This is a sum the tenant-buyer pays to the seller to secure the purchase price and their option to purchase the property at the end of the rental term. This initial option payment, amounting to 3-5% of the price of the home, is usually non-refundable but is put towards the purchase price of the home when the tenant-buyer exercises their option to purchase.
Additionally, the tenant-buyer makes monthly payments to the owner. This monthly payment includes the rent as well as a small option payment that accumulates as credits towards the final purchase of the home, reducing the final purchase price for the buyer. The monthly option payments are non-refundable and acts as compensation to the seller for reserving the right to purchase the property to the tenant-buyer alone until the agreement ends.
The rental term is negotiable but can last anywhere from 1-5 years with an average of 2-3 years. The term is designed to be just long enough for the tenant-buyer to get their credit back in order and be able to qualify for a mortgage of their own by the end of the term.
The future purchase price of the home is negotiable but is commonly higher than the current price based on historical increases in home prices in the area. Once agreed upon, however, the price is set irregardless of the future price of the home.
One question you may be asking yourself now is, given it's complexity compared to traditional home purchases, why would anyone use Rent-to-Own as a way of owning a home? There are several reasons and benefits to using this method but like anything else, it isn't for everyone. Clients whom may find this method advantageous may include those who cannot get traditional bank financing due to poor credit, no credit, self-employed, new to Canada, recently divorced, past bankruptcy, or needs time to save for a down payment but wants to get into a home today.
For these people, Rent-to-Own allows them to get into their home today while:
- they improve their credit scores to get bank financing
- they save up for a down payment
- they lock in a purchase price protecting them against any price increases
- any improvements the tenant makes to the home that increases its value over and above the purchase price will be equity that is entirely the tenant's to keep
- they familiarize themselves with the neighborhood and schools in the area
- they get to know whether home ownership is really for them
There are benefits to the seller as well (otherwise, they wouldn't do this) and these include:
- getting income from their property
- having an invested tenant-buyer who will take good care of their future home
- a potentially higher sales price
- a way to unload an under-performing rental property
- access to a larger buyer market (those who do not qualify for bank financing)
Risks of Rent-to-Own
As advantageous Rent-to-Own is for both buyer and seller, there are some pitfalls to watch out for:
- Unscrupulous owners who qualify hopeful tenants for a rent-to-own whom they know will never qualify for a traditional mortgage with aims to pocket their option money and keep the house, leaving the tenants heartbroken and out thousands of dollars. Request full transparency from whomever you are working with. If something feels off, walk away.
- The housing market may be in a downturn causing home prices to drop lower than the contract price. In this situation, the buyer may risk over-paying for the property or being forced to walk away and forfeit their option payments. Alternatively, the seller may lose money on the sale if they have no choice but to sell at a lower price. Options here include a vendor take-back mortgage, negotiating a new price, or extending the rental term until prices recover.
- The tenants may still not be able to qualify for a mortgage at the end of the rental term. If the owner agrees, the term may be extended if the tenants need a little more time to get their ducks in a row. Otherwise, the tenants may be forced to walk away and forfeit their option payments.
- The tenant may decide not to buy in the end leaving the owner to start all over with a new tenant-buyer (the owner is at least compensated with the option payments)
- The home prices may rise faster than expected forcing the owner to leave money on the table due to the locked-in purchase price. Of course, this is a benefit for the buyer.