First Time Buyer Friday #10 – How Does Rent To Own Work?
In my continuing series, First-Time-Buyer Fridays, I answer a common question from a first-time buyer. If you have a question to submit, first-time-buyer or experienced investor, put one in the comments below, or fire me an e-mail at Tim@TimAyres.ca.
What's the Deal with Rent-To-Own?
Q. I’ve heard about people being able to rent-to-own a home? Is this legit? How does it work? Why don’t more people do this?
A. At first glance, renting to own a home sounds like such a good deal. No or little money down, similar payments to rent, going towards your equity instead of in the landlord’s pocket. And for many people, this would work out just fine. However, it’s not as simple as it sounds.
A rent-to-own program is essentially an agreement for sale, which is a legal term that means you are agreeing to purchase the property from the owner on a set date in the future, for an agreed-upon price today. Payments on an agreement for sale are credited to the purchase price, and used to pay any interest, if any. Essentially, the seller is financing your purchase of the property until such time that you can qualify for a mortgage and pay out the rest.
Most rent-to-own programs boast that they are “interest-free,” but while you’re paying no interest, only a portion of your payment is applied to the principal. The rest goes directly into the owner’s pocket as rent. So, no, it’s not interest in the traditional sense of the word, but it’s essentially six-of-one, half-dozen-of-the-other, isn’t it?
From a buyer’s perspective, a rent-to-own scheme is attractive if that buyer would likely not be eligible for traditional mortgage financing due to poor credit, and/or would not have sufficient funds available for the required minimum 5% down payment. By renting-to-own, the buyer is essentially paying a down payment (and rent) to the seller while living in the house. At the end of the term of the rent-to-own contract (one to five years), the buyer/renter is obligated to pay the outstanding balance to the seller/landlord, which would be the original price agreed on at the start of the term, less the amount of the portion of the monthly payments allocated to the purchase price and the buyer/renter’s initial deposit. The agreement for sale is registered on the title to the property which ensures that the seller/landlord cannot simply sell the property to somebody else.
Example: if the purchase price of the home was $400,000, and the rent was $1750 per month, 30% of which was assigned to the purchase price ($525), three years of payments would net $18,900 which would leave an outstanding balance of $381,100. This balance would need to be paid to the owner at the end of the term, assumedly by a mortgage that the buyer would now qualify for (a bank would hopefully recognize the history of monthly payments to improve the buyer’s credit situation). Please note that these numbers are for illustration only, and the length of the term and amount of the monthly payment which is applied to the purchase could be more or less, depending on what is negotiated.
What happens at the end of the term if the buyer still doesn’t qualify for a mortgage to pay out the outstanding balance to the seller? In this case, the seller would be eligible to keep the deposit and all payments made by the buyer during the term. The same goes if a buyer defaults on a payment.
From the seller/landlord’s perspective, is this a good deal? I know I wouldn’t do it. First, unless you own the property outright or have a small mortgage, you’re going to be making payments on the property until the end of the rent-to-own (agreement for sale) term when you get your lump-sum from the buyer. If the renter/buyer’s payments aren’t large enough to cover your mortgage payments, you’re still paying out of pocket and still need a place to live. Second, if you have a small enough mortgage or own the property outright, why not just rent it out to good tenants and have a nice income stream for life? Why sell an income-producing asset at the end of the term? And thirdly, for every rent-to-own buyer in the marketplace, there are probably several more willing and able outright purchasers for your property. Why wait to get your cash now? You’d earn some rent/interest on the agreement for sale, but the opportunity cost of doing so could exceed the benefits, especially if the buyer defaults and the property has lost value. This is probably why you don’t see more agreement for sale/rent-to-own properties on the market – there isn’t a compelling incentive for owners to agree to it.
I think there are better ways to improve your credit and to save money for a down payment to take advantage of home ownership. RRSP withdrawals, the tax-free-savings-account, and other financial tools come to mind. However, you’d probably talk to families who’ve been able to purchase a home through a rent-to-own scheme that are perfectly happy with the result.
In any case, I would highly recommend having a lawyer and/or an accountant review any rent-to-own or agreement for sale contract you are considering entering into, either as buyer/tenant or as seller/landlord to make sure you understand the benefits and risks. There are many schemes that would be very one sided toward the landlord/seller, so be sure what you’re entering into is fair and equitable.
What do you think? Have you ever purchased a property this way or know somebody who has? I’d love to read your comments below.
If you have any questions about renting to own, agreements for sale, how you can make home ownership a reality, or any other real estate matter, please give me a call at 250-885-0512, e-mail me at Tim@TimAyres.ca or fill in my contact form. You can connect with me on Twitter at Twitter.com/TimAyres.
-Tim Ayres – Sooke Real Estate Professional
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