Buying a home with bad credit can be a challenge. Depending on your situation and the severity of your credit problems, you might not be able to qualify for a mortgage without first working to improve your credit. For that reason, some people opt to try a different strategy for becoming a homeowner called rent to own.
A rent-to-own agreement may give you the option to move into the home you want to buy now without qualifying for a mortgage. Then, after you lease the property for an agreed-upon period of time, you have the option to buy it.
As a buyer, you might be attracted to a rent-to-own arrangement to give yourself time to work on obstacles that are preventing you from qualifying for a mortgage. Credit problems, debt-to-income ratios that are too high, and other challenges may all fall into this category.
On the surface, renting to own sounds like the best of both worlds. Yet in reality, the situation can be complicated and a lot can go wrong.
As a buyer in a rent-to-own arrangement, you don’t have access to many of the protections that are available to homeowners — leaving you and your financial investment in a potentially vulnerable situation. Before you enter into a rent-to-own agreement, it’s important to understand how the process works and consider the dangers of this type of arrangement.
A rent-to-own contract is a real estate agreement that allows you (the tenant) to lease a property for a set period of time. Then you have the option to purchase the home if you desire to do so before the lease expires.
In general, you can expect the monthly rent payment on a rent-to-own home to be more than the fair market value of the property. In other words, you could probably rent a comparable property for less money without adding on the option to buy. Yet depending on your rent-to-own agreement, the landlord may hold aside a portion of the money you pay each month and apply it toward your future down payment.
Rent-to-own contracts may also include a feature called an “option fee.” An option fee is an upfront deposit that often costs around 2-7% of the future purchase price of the property. This fee can be sizable. On a $200,000 property, a 5% option fee would be $10,000.
The option fee essentially locks in a property so the owner doesn’t sell it to any other party while you’re leasing it. If you follow through and buy the property before the end of your lease, the option fee may go toward your down payment or purchase price. However, if you change your mind or can’t qualify for a mortgage to buy the property at the end of the lease, the seller may be able to keep your option fee depending on the terms of your contract. (Translation: It could be an expensive gamble.)
Most rent-to own contracts are broken down into two sections:
If you’re signing a lease-option contract, you may have the opportunity to purchase the property before the lease period ends. A lease-purchase agreement, by comparison, may contain a commitment that obligates you to buy the property at the end of your lease.
In either scenario, you should treat a rent-to-own contract as seriously as you would treat a contract to purchase a property outright. Therefore, it’s wise to hire a reputable real estate attorney to represent you and review the contract before you sign or make any deposits. Finding an experienced real estate agent that is familiar with rent-to-own agreements could also be beneficial.
Many of the people who consider rent-to-own agreements do so because they’re not in a position to qualify for a mortgage. Yet although it tends to be easier to enter into a rent-to-own agreement, there are still requirements you may need to meet before a program may be willing to work with you.
Every program and seller is different, of course. Yet here are some examples of qualification requirements you might come across when you rent a home with the option to buy it later.
Keep in mind that even if you’re eligible for a rent-to-own program, you’ll need to be able to qualify for a mortgage by the end of your lease. Otherwise, you won’t be able to purchase the home and the seller will likely keep any option fee you deposited to move into the home. For most people, rent-to-own is a huge financial risk.
One of the most common reasons people consider leasing a home with the option to buy is due to credit-related challenges. In many cases, a bad credit score or other credit issues will not disqualify you from a rent-to-own program or agreement. That being said, sellers and rent-to-own companies may have some credit qualifications that you will need to satisfy.
Divvy, for example, accepts applicants with a FICO® Scores as low as 550. Coldwell Banker, by comparison, requires a minimum household credit score of 600 or above.
There are also certain types of credit issues that might disqualify you from a rent-to-own opportunity, such as:
Each owner and rent-to-own program is different, of course. So, your best bet is to find out the specific requirements of the seller or program you are considering to see if you meet the eligibility requirements to participate.
Below are three benefits that a lease purchase agreement could offer you.
With most rent-to-own arrangements you will need to satisfy a number of requirements that pertain to your income, employment history, credit, and more. Yet the approval criteria for entering into a lease purchase agreement tends to be more lenient compared with a mortgage lender’s requirements in the same areas.
If you’re not in a position to qualify for a mortgage yet, a rent-to-own agreement could give you the chance to move into the home you want without waiting. You can work on improving your credit, building credit, saving a down payment, and more all while already living in the home you love and locking in its purchase price.
Renting to own gives you a chance to try before you buy. In other words, you can test out a home and the neighborhood it’s located in before you make a long term commitment. If you rent a home with the option to buy and discover that it’s not the right place for your family, you can back out and opt not to move forward with the purchase. (There is, of course, a cost associated with changing your mind. See below for more details.)
There are many downsides involved with renting a home with the option to buy. The drawbacks, including the three obstacles below, seem to outweigh the benefits where rent-to-own arrangements are concerned.
In general, it is more expensive to rent a home with the option to buy than to simply rent a property in the traditional sense. Even if a portion of the rent goes toward your down payment, you could still lose that money (and your upfront option fee) if you’re unable or unwilling to buy the home at the end of your lease.
Furthermore, owners may mark up the future purchase price of a property to allow for appreciation. That means the sellers may guess how much they believe the home will be worth at the end of your lease and set the purchase price accordingly.
Depending on the terms of your rent-to-own contract, you might be responsible for any repairs or maintenance on the property during your lease period. In traditional rental situations, such expenses are something the owner tends to cover. This is an important factor to consider since the average emergency repair costs $2,231.
Rent-to-own agreements may contain loopholes that allow the seller to back out of the deal and keep the extra money you believed would go toward your future down payment. Make a monthly payment late, for example, and your future right to purchase might be gone. Or if the original seller dies or decides to sell the property to someone else and you have an unrecorded deal, the new owner might not honor your rent-to-own arrangement.
Many would-be homeowners have horror stories of surprise foreclosures during rent-to-own agreements, complications from unpaid property taxes, and more. The Federal Trade Commission warns of many outright scams you could face as well. There are many dangers you face as a buyer participating in a rent-to-own agreement, and unfortunately, not many protections to offset them.
Most rent-to-own agreements do not show up on your credit reports, though there may be some exceptions to this rule. Remember, an item must appear on your credit with at least one of the major credit bureaus (Equifax, TransUnion, or Experian) in order to have any potential impact on your credit.
Keep in mind that even if a rent-to-own agreement doesn’t show up on your credit report, some landlords may be willing to report your rent payments through a third-party service. If you find a landlord who is open to sharing your positive payment history with the credit bureaus (via a third party), your monthly rent payments could have the potential to help you build your credit history and score.
There’s a chance that paying your rent late could have a negative impact on your credit. This fact is true for traditional rental situations and with less common rent-to-own programs.
If you fall behind on your rent, the property management company might enlist the help of a collection agency to collect your past-due balance. In some cases, a collection agency might buy the debt outright. In either of these scenarios, a collection account could show up on your credit report.
Collection accounts do have the potential to damage your credit score. Furthermore, if your landlord is using a third-party service to report your monthly payments to the credit bureaus, late payments could damage your credit long before a collection agency gets involved. Even the occasional 30-day late payment might impact your credit score in a negative way.
It’s important to make every effort to pay your rent on time, especially in a rent-to-own scenario. In addition to possible credit score damage, late payments might also disqualify you from the option to purchase the home at the end of your current lease.
Deciding to rent a home with the option to purchase it down the road is risky. There are many ways for the process to go wrong, and you could lose a lot of money if it does.
For most people, it may be best to consider saving a down payment on your own and working on your credit or other issues that are stopping you from qualifying for a mortgage. Opting for a traditional rental until you’re in a position to qualify for a mortgage is often the safer choice.
However, if you decide that you want to give rent-to-own a try, remember that the terms of the agreement are negotiable—just like when you purchase a home. You can ask the seller to adjust the sales price, the amount of rent that goes toward your down payment, and many other aspects of the agreement. There’s no guarantee that the seller will honor your requests (especially if there is high demand for the property), but you won’t know unless you ask.
Finally, make sure that you hire an attorney to represent you from the start. It’s a good idea to find a real estate agent to represent you as well—someone who does not also represent the sellers of the property you’re considering. Renting to own is a big investment, even if it is broken down over time. It’s important to make sure that you have the right people in your corner to protect you if you decide to take this risk with your money.
Michelle Lambright Black is a nationally recognized credit expert with two decades of experience. She is the founder of CreditWriter.com, an online credit education resource and community that helps busy moms learn how to build good credit and a strong financial plan that they can leverage to their advantage. Michelle's work has been published thousands of times by FICO, Experian, Forbes, Bankrate, MarketWatch, Parents, U.S. News & World Report, and many other outlets. You can connect with Michelle on Twitter (@MichelleLBlack) and Instagram (@CreditWriter).
Ana Gonzalez-Ribeiro, MBA, AFC® is an Accredited Financial Counselor® and a Bilingual Personal Finance Writer and Educator dedicated to helping populations that need financial literacy and counseling. Her informative articles have been published in various news outlets and websites including Huffington Post, Fidelity, Fox Business News, MSN and Yahoo Finance. She also founded the personal financial and motivational site www.AcetheJourney.com and translated into Spanish the book, Financial Advice for Blue Collar America by Kathryn B. Hauer, CFP. Ana teaches Spanish or English personal finance courses on behalf of the W!SE (Working In Support of Education) program has taught workshops for nonprofits in NYC.