Rent-to-own agreements: how do they work and can they offer a path to homeownership?

Sometimes, people may feel like they are stuck renting because homeownership is out of reach financially. But what if renting were actually a step on the path toward becoming a homeowner? In the case of rent-to-own agreements, it can be.

These agreements are essentially rental leases that include an option (or, in some cases, an obligation) to eventually buy the property after living in it for a period of time. During this time, some of the rent you pay may go toward a future down payment. While this likely sounds like an appealing prospect, and it can have upsides, there are some definite drawbacks worth weighing first.

What is a rent-to-own agreement?

A contract that effectively “gives renters the option to work toward buying the home they already live in,” said Bankrate. Because of this dual purpose, the contract contains two parts: a standard rental lease detailing your obligations as a renter, and a separate option-to-purchase contract.

As part of the agreement, a portion of the rental payment you make each month may get diverted toward your eventual down payment, an arrangement known as “rent premiums” or “rent credits,” said NerdWallet. You may also need to make a non-refundable deposit upfront, known as an “option fee,” that is similarly a portion of the home’s purchase price, “typically 1% to 7%.”

While you continue to rent, that money will be held in an escrow account until you purchase the home. Typically, “your rent-to-own agreement will spell out how long you can rent the home before you must decide whether or not you buy it,” a period of time that is “often 2 to 3 years,” said Rocket Mortgage. Depending on the specifics of the contract, that eventual purchase may be an option (a lease-option contract), or it may be a contractual obligation (a lease-purchase contract).

What are the pros of rent-to-own homes?

One of the obvious upsides is that you are accruing a down payment while you live in the home as a renter. This can be helpful if you have been struggling to set aside the necessary amount. Plus, while you save, you have built-in time to improve your credit, if that is necessary for you to secure a competitive mortgage offer.

The arrangement can also offer some stability, not to mention logistical relief. “Since you’re already living in the home, you won’t have to deal with the expense and hassle of moving again,” and you will also have the chance to “familiarize yourself with the property and neighborhood,” said Redfin.

Are there downsides to rent-to-own?

Definitely. For one, “if you change your mind or you can’t buy the home when the time comes, you could lose a lot of money,” said Investopedia. “At a minimum, you will lose your option fee,” and “if you signed a lease-purchase contract, you could face more financial fallout.” Even if you feel confident you will follow through, tread carefully: “Often, the contract terms are so rigid that the renter winds up defaulting and losing all the money,” said The New York Times.

Further, while it may sound smart to lock in a home purchase price when you sign the contract, often years ahead of purchase, this might not actually end up being a great deal. “That price is often higher than the home’s fair-market value,” said the Times, citing Karen E. Brown, the director and managing attorney of the Home Defense Program at the Atlanta Legal Aid Society. Often, the “inflated prices cause problems when the property is appraised for a mortgage.”