First-time homebuyers are in a particularly tough position. While many buyers in the market have the advantage of selling their current homes to cover the down payment and closing costs on their new homes, first-timers don’t have a home to sell; they have to come up with the money through smaller savings and investments.
So first-time buyers are getting creative. They’re turning to rent-to-own homes for access to homeownership. In 2023, the rent-to-own market was given an $11.95 billion valuation, with projections for the market to reach $18.17 billion by the end of 2029.
In this article, we’ll break down rent-to-own homes, explaining what they are and how they work. We’ll also give you the pros and cons to help you decide if a rent-to-own home is the right fit for you. And we’ll explain how real estate investors can benefit from the increased interest in rent-to-own homes.
What are Rent-to-Own Homes?
Rent-to-own homes are single-family residences that can be leased with the option to purchase the home at the end of the lease term.
For buyers, this means you can lock in your option to buy a specific home before you’re 100% ready to complete the purchase. For example, if you need time to save for the down payment or improve your credit score to qualify for a home loan, a rent-to-own arrangement would essentially give you dibs on the home while you work toward being homeowner-ready.
How Do Rent-to-Own Homes Work?
Here are the basics of how rent-to-own homes work:
The current owner and new renter enter into a contract that will allow the renter to purchase the property at the end of the lease term.
The purchase price is typically agreed upon upfront. It is usually higher than current home prices because real estate tends to appreciate over time. So by the time the lease expires, the property will likely be worth more than it was at the beginning of the lease.
There is an upfront fee charged for the purchase option. This fee is often set between 1% and 5% of the agreed-upon purchase price. If the purchase option is used, the fee goes toward the down payment. If the renters decide not to purchase the property at the end of the lease term, the fee is forfeited to the owner.
Monthly rents are higher than on a normal rental because they include a “rent premium” which is used to help the renter build equity in the property. For example, the normal rent could be $2,500 per month and a rent premium of $500 could be added to this. Every month, the renter would pay $3,000. $2,500 would go to the owner as rent, and $500 would be held safely in an escrow account. If the renter purchases the property as agreed, the rent premium can be applied to the down payment. If the renter does not purchase the home, the premiums are forfeited to the property owner.
The lease term is often longer than a year because the renters need time to build up their equity through the rent premiums, save for a down payment, and build/maintain good credit. This is why rent-to-own lease terms are often 2-5 years.
Example of a Rent-to-Own Arrangement
Let’s say you decide to enter into a rent-to-own arrangement under the following terms:
Purchase price: $700,000
Upfront purchase option fee: $7,000
Monthly standard rent: $2,500
Monthly rent premium: $500
Lease term: 3 years
Every month, you would pay $3,000 in total rent. $2,500 would go to the owner, and $500 would be held in your escrow account. At the end of the three-year lease term, you would have $18,000 in your escrow account from rent premiums ($500 times 36 months) plus the initial $7,000 purchase option fee. This gives you a total of $25,000 to apply to your purchase.
Depending on your credit, you might be able to qualify for a conventional home loan with a down payment of as little as 3% or an FHA loan with a down payment of as little as 3.5%. And, since $25,000 is 3.57% of the $700,000 purchase price, your rent-to-own arrangement could potentially completely cover your down payment.
The rent premiums essentially serve as a fool-proof down payment savings plan.
Rent-to-Own Contract Types: Lease Option vs. Lease Purchase
There are two types of rent-to-own contracts: lease option contracts and lease purchase contracts.
Lease option contracts give the renters the choice to purchase the home at the end of the lease term for the agreed-upon price or to walk away. If the renters choose to purchase the home, the upfront purchase option fee and rent premiums can all be applied to the down payment. If the renters decide not to purchase the property, the fee and premiums are forfeited to the owner.
Lease purchase contracts require the renters to purchase the home at the end of the lease term for the agreed-upon price. As long as the renters follow through with the purchase, the upfront purchase option fee and rent premiums can all be applied to the down payment. Suppose the renters fail to complete the purchase, perhaps because they cannot qualify for a home loan or because they have decided to relocate. In this case, the fee and premium are forfeited to the owner, and the owner can sue the renters for breach of contract.
Pros and Cons of Rent-to-Own Homes
As you can imagine, rent-to-own homes have pros and cons for renter-buyers and property owner-investors. Here are the advantages and potential downsides to consider.
Advantages of Rent-to-Own Homes for Renter-Buyers
More time to save money. You know you want to buy, but you just don’t have enough money yet. A rent-to-own home buys you time while reserving a home you love.
A built-in down payment savings plan. The monthly rent premiums effectively force you to set aside funds every month for the down payment.
A known purchase price. Since the purchase price is agreed upon upfront, you know exactly what number you’re working toward. And you’re protected from sudden jumps in home prices.
Time to improve credit scores. Building credit takes time, and a rent-to-own arrangement gives you years to improve your credit so you can 1) qualify for a home loan, and 2) qualify for a favorable interest rate.
Predictable payments. Your rental rate is locked in for the lease term, protecting you from rental increases.
Potential Downsides of Rent-to-Own Homes for Renter-Buyers
Higher rental rates. Since your monthly rent includes the rent premium, you need to budget for higher-than-average rent expenses during the rent-to-own lease term.
The upfront expense of the option fee. The lease option fee may represent a substantial upfront financial commitment.
Potential forfeiture of the lease option fee and rent premiums. If your plans change and you cannot complete the purchase, you could lose your lease option fee and your rent premiums.
The risk of home price decreases. While real estate values always grow over time, they can experience temporary slumps. It is possible, albeit unlikely, that the home will not be worth the agreed-upon purchase price at the end of the lease term.
Maintenance responsibilities may fall to you. Depending on the contract terms, you may be responsible for property maintenance and repairs during the lease term.
Advantages of Rent-to-Own Homes for Owner-Investors
Reliable income. In addition to the standard rental income, the owner receives the upfront purchase option fee and the rental premiums (either as partial payment for the home purchase or as forfeited fees if the renter doesn’t complete the purchase.
Less turnover. Longer lease times mean less tenant turnover. This means lower turnover expenses and vacancy losses.
Renters have a vested interest in the property. The renters are more likely to take good care of the property, knowing that they will become the owners at the end of the lease.
Potential Downsides of Rent-to-Own Homes for Owner-Investors
Locked-in rates. Because rental rates and the purchase price are agreed upon upfront, the property owner may be leaving cash on the table if rents or property values rise more than expected during the lease term.
Inaccessible equity. Lenders are less likely to offer home equity loans, home equity lines of credit (HELOCs), or cash-out refinancing if the property is being leased to sell.
Legal requirements and expenses. The additional legal complexity of a rent-to-own contract will likely require the involvement of a real estate attorney, along with their high hourly rates and/or retainers.
How to Find Rent-to-Own Homes (or List Them for Sale)
If you’re looking for a rent-to-buy home to purchase, you may want to start by reaching out to local real estate agents. A good agent has a network of home sellers, real estate investors, and industry professionals who might be able to offer you a rent-to-home deal.
You could also check with the growing number of rent-to-own home platforms that match renter-buyers with available properties. These platforms include Rent to Own Labs, Home Partners of America, and Divvy.
If you’re an owner-investor looking for a renter-buyer, you should check the same sources. Local real estate agents and online rent-to-own platforms can help you find your new tenant and potential future buyer.
More Real Estate Investing Options
Rent-to-own isn’t the right fit for every homebuyer or every investment property owner.
If you’ve decided rent-to-own isn’t the right path for you, consider other real estate investment options that may be a better fit, including:
House hacking. House hacking is when you use your home to generate income.
Real estate syndication. Similar to real estate crowdfunding, syndication pools funds from multiple investors to finance a real estate project. The rental income and/or proceeds from the sale of the completed development are then distributed to the investors.
