What is a Rent-To-Own Home?
Are you getting fed up of renting apartments? Are you thinking of taking the next step toward buying a house of your own? Maybe you’re still living at your parents’ house, but the thought of moving into an apartment doesn’t seem appealing. Then again, you might want to be a homeowner, but don’t currently have the finances necessities to qualify for a mortgage, such as a good credit score or enough money for a down payment. You may have even gone through a recent consumer proposal or bankruptcy, both of which can also make it hard for you to get the approval you need. So, if you still want a house someday, you might have to consider other alternatives. Whatever avenue you choose, homeownership is not an easy task. It takes a lot of time, money, and effort to find the home you want to make yours. But, for some, owning a house is the ultimate life goal, and chances are that if you’re one of those prospective homeowners, you’ll do what you need to do so you can walk away with keys in-hand. That’s where “rent-to-own” (also known as “lease-to-own”) homes can come into play.
Thinking of leasing a car or entering into a lease-to-own agreement? Read this first.
However, what exactly is a rent-to-own home? And, for that matter, what about this homeownership option appeals to Canadian renters? Like with any significant financial commitment involving real estate, rent-to-own deals do come with their upsides and downsides, so it’s best to know a bit about them before you determine it’s the right path for you. So, if you’re thinking about renting your next home so that you can possibly own it one day, or if you’re just curious about how a rent-to-own deal works, keep reading, we have the answers you need.
How Does Renting-To-Own Work?
When it comes to living in North America, rent-to-own homes are more often seen in the United States. However, they do show up all over Canada, especially in provinces like British Columbia, Alberta, and Ontario, where housing prices can be astronomically high in and around the more populated areas. In fact, one of the main reasons why rent-to-own homes are so appealing is because they’re presented as a more affordable option for homebuyers who either don’t qualify for a typical mortgage or don’t have enough money to afford a reasonable down payment. They’re also alluring to people who already own a home and are trying to sell it, or for real estate investors, both of whom are interested in the possibility of earning a profit once the home is sold.
Essentially, a homeowner or investor will rent out a house that’s already in their name, similar to how a landlord would with an apartment. Potential homeowners or tenants can then rent the house, making regular payments to their landlord. Each rental home comes with a particular rental contract/agreement that the tenant must adhere to if they want to remain living there. Strictly speaking, there are two types of contracts that are offered, known as “option-to-purchase” and “lease-purchase”. If the renter chooses the option-to-purchase, they’ll sign an agreement that states that they have the option, but not the obligation to buy the house when their rental term is over. If they choose a lease-purchase, it means they have agreed to buy the house at the end of the term.
Note: Below, we’ve provided a basic example of how a typical rent-to-own agreement tends to work. However, every rent-to-own contract is different, meaning certain conditions apply in some cases where others will not. While some landlords will offer the option-to-purchase, some won’t, and so forth. So, if you are thinking of choosing a rent-to-own home, always read your contract over carefully and seek the advice of a professional if you have any concerns.
Want to know how much it costs to purchase a home in your province? Check out this infographic.
The Option Consideration
With most rent-to-own agreements, the potential tenant will be required to pay what’s known as an “option consideration” or “option money”. This is a non-refundable, but an often negotiable deposit, which usually amounts to about 2-5% of the home’s final asking price. The option consideration is a separate contract that gives the tenant the right, but not the obligation to buy the house at the end of the rental period. If the tenant doesn’t wish to pay for the option consideration, the landlord might still let them rent the home, but they will not have the right to purchase it at the end of their lease. Depending on the terms of the agreement, the full sum or part of the option money may go towards the tenant’s eventual down payment on the home, but again, every contract is different.
After the agreement has been confirmed, the tenant will make regular payments, usually on a monthly basis, over several years (1-3 years is most common). The payments are divided into two parts, with one larger portion (about 75%) of each payment going toward the rental fee and the other (about 25%) going towards the down payment and eventual home equity. Once the lease is over, if the tenant still wishes to or is obligated to buy the house, they will have hopefully paid off enough of the down payment and raised their credit score sufficiently to qualify for a regular CMHC (Canadian Mortgage and Housing Corporation) insured mortgage. If the tenant’s agreement to purchase the home is optional and they don’t like the house or have any other reason not to buy it when their rental term ends, they can walk away from the deal.
What’s the minimum credit score for mortgage approval in Canada? Find out here.
The Final Asking Price
Once again, the terms of the rental contract will dictate what the new potential homeowner ends up paying for the home if and when they decide to buy it. Under some contracts, the final asking price for the home will be agreed upon and locked in before the tenant moves in. However, some rent-to-own contracts state that the asking price will only be determined at the end of the leasing term and will be based on the home’s appraised market value. Actually, the majority of tenants prefer to have the asking price locked in because the real estate market is always fluctuating.
A Basic Example
For the sake of argument, we’ll say that the rent-to-own agreement is for a 3-year contract. The renter agrees to pay $1,000 in rent per month, with an additional $500 per month that goes towards the down payment. Here’s how it will work:
- The final asking price for the home is locked in at – $350,000
- The upfront deposit is – $8,750 (2.5%)
- The mortgage remaining at the end of the rental term is now – $341,250
- The monthly rent is – $1,000
- The monthly portion going towards the down payment is – $500
- $500 x 12 (months) = $6,000 (per year for down payment)
- $6,000 x 3 (years) = $18,000
- $341,250 – $18,000 = $323,150 (remaining on mortgage after 3 years)
So, by the end of their 3-year rental contract, the prospective homeowner should have invested $18,000 towards the down payment on the home. Here’s the problem, they’ve also paid $36,000 in rent over those 3 years, all of which will not be going towards the initial mortgage price. This means that they’ve invested $62,750 towards the home, but only $26,750 will actually go towards the final asking price.
The Advantages and Disadvantages
That leads us to our next section. As we mentioned earlier, all rent-to-own agreements come with advantages and disadvantages for both the seller and the renter, so it’s very important to know what they are before you sign any contracts.
For The Seller or Real Estate Investor
- Since a percentage of the renter’s monthly payments are going into the seller’s pockets, they could stand to receive a very decent profit on their investment, especially once the house is finally sold.
- Because a house is more desirable than the average apartment, they’re also in a position to charge a far higher amount for rental fees.
- If the tenant chooses the option-to-purchase consideration, the deposit fee can be collected up front. If the tenant doesn’t purchase the home at the end of their rental term, they’ll forfeit their deposit to the landlord.
- While the property still belongs to the seller, they are usually not responsible for any repairs or maintenance that needs to be done on the house. Also, if the tenant makes any renovations, it comes out of their pocket, not the seller’s.
- If the contact is a lease-purchase or the tenant does want to buy the home, the seller not only retains the money they’ve earned from rental fees, but their house is will officially be sold.
- Rather than putting their house up for sale right away, sellers must now go through the same tenant-screening process a typical landlord would (performing background and credit checks, etc.).
- If the contract is an option-to-purchase, the renter is not obligated to purchase the house at the end of the rental term. They’ll be allowed to terminate the deal at any time or when their rental agreement expires. The seller then needs to find another renter and arrange a whole new screening process.
- Since the home is still in the seller’s name, they’ll have to continue making mortgage payments to their lender until the home is officially sold. The rental fees might only just cover those payments.
For the Tenant/Potential Homeowner
- If the contract is an option-to-purchase, the tenant has the right to terminate their rental agreement at the end of their rental term. This means they can have a “test-run” with the house. If they don’t like the neighborhood, the contract terms or the house itself, they don’t have to buy it.
- If the tenant has poor credit, a few years of renting can give them sufficient time to raise their credit score through other means, such as timely credit card payments, etc. Once their credit score is raised, they’ll have an easier time qualifying for a conventional mortgage.
- The non-rent portion of the payments that the tenant makes goes towards the down payment on the home. For those who cannot initially afford said down payment, they can both add to it gradually and have time to build up their finances.
- If the asking price is locked in, the tenant will then pay that price for the home (not including rent payments) at the end of their contract, even if the real estate market fluctuates and the house rises in value.
- If the tenant’s finances and credit score have not improved by the time their rental agreement expires, they may not receive the necessary financing to purchase the house.
- If the contract is an option-to-purchase, and the tenant has paid for the option consideration but does not purchase the house, their deposit will be lost.
- Unlike an apartment, in some rent-to-own cases, tenants are responsible for all required repairs and maintenance. They might also have to pay for homeowner’s association fees, property taxes, and insurance.
- The landlord still technically has the property in their name and must continue to make the mortgage payments. So, if they start defaulting, the home might be foreclosed.
- Some landlords are also more strict than others. So, if you default on your payments for too long (sometimes 90 days), they might threaten to evict you or take legal actions against you.
- Because the asking price of the house is coupled with the rental fees and all other homeowner related costs, the renter might end up paying much more than the house is actually worth and might not receive their investment back if they decide to resell it in the future.
Know Who You’re Dealing With
As it is with all real estate transactions, it’s extremely important that if you’re thinking about renting or renting out one of these homes you know exactly who you’re dealing with. The problem with some rent-to-own cases is that a third party association will sometimes get involved. This third party jumps in the middle of the landlord and the tenant, claiming to better manage the money that passes between them or to guarantee the landlord another buyer if the current tenant doesn’t purchase the home. They’ll, of course, charge a fee for their services. Unfortunately, these third-party associations can be scam artists, who will take their fee, then back out of the deal, as was the case with the Golden Oaks Enterprises real estate scandal of 2013 in Ottawa.
Click here to find out why syndicated mortgages might not always be a safe investment.
For that reason alone, it’s always a good idea to consult a professional before you decide to rent a home or put your home up for rent. In fact, there are qualified real estate lawyers that specialize in making sure investors and homeowners are getting properly examined, legitimate contracts.
Whether you’re renting or buying, it’s always important to understand the true cost of your financial commitment.
Consult a Professional
As we just mentioned, it’s always important to speak to a professional advisor before making any big financial decisions, especially when it comes all avenues of the real estate market. It’s apparent that rent-to-own homes, like any form of homeownership, do come with their upsides and downsides. So, for anyone out there interested in either becoming a renter or seller of a rent-to-own dwelling, it’s best to make sure you understand all of these factors before you make your decision. And, in most cases, a bit of online research is not enough. To see that your investment is safe, it can be beneficial to consult both a real estate professional and a financial advisor. Remember, becoming a homeowner is one of the most important and expensive decisions you’re likely to make in your lifetime, so it’s essential that you take the proper time to think it over.
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