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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?

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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  • Here is a comment I received via e-mail:

    I disagree with your positions on AFS’s. They serve a very viable purpose in proper application.
    The variables are, and always will be, the Purchaser’s ability (or inability) to float a down payment or qualify for conventional mortgaging. The Vendor may also want to space his capital gain recapture over a few years before title transfers. The property may be a toughie to sell in today’s tenuous market, and finally, good tenant prospects are not as prolific as they used to be.
    As an ex-realtor I used this sales vehicle several times to good advantage. The only encumbering feature was a reduced or delayed commission to the broker.
    I would recommend it in a heartbeat where conventional sales methodology cannot work well. More young buyers could get into the market if AFS’s were offered by ethical and tactful Vendors.

    Doug

  • Thanks for your comment, Doug, I’m sure my readers will appreciate a second point of view.

  • just me

    Tim, I can’t figure out what AFS stands for? I know it must just be another way of saying “rent to own”

    • AFS stands for agreement for sale, another term for rent to own.

  • May

    I am in a situation were I have to move due to a job change. I do not have the money for the down payment and closing cost. I am looking at renting or rent to own. If these were the choices, would you consider a rent to own? I have started a tax-free-savings-account but it does not have enough in it yet to help.

    • Here is a comment by Lori, who has had rent-to-own work in her favour before:

      I sold my Northern Ontario property as a rent-to-own and was VERY pleased with the results. What I did was to break down the payments over a 10 yr period, with a suitable interest rate.

      The purchaser was a couple who would never have been able to qualify for a mortgage.

      For myself, this property was up north and would have been nearly impossible to sell. The bonus for myself turned out to be that when my husband & I divorced and he refused to pay child support – I was awarded the payments to help support myself and child!

      I have remained in touch with the couple (the property is paid out) and they are so happy and still live there! It was a win-win situation.

      Now, I am currently considering relocating from Gibsons to the Powell River area. In this home market I fear many young people would be unable to become 1st time own owners and so am considering doing this again.

      Thanks for the input, Lori!

      -Tim

  • Lois

    If a person has an AFS registered on title they can claim home owner grant, if paying the property taxes is part of their agreement. The lawyer’s office said it would cost $700-$800 to draw up an AFC and register it, so not worth it for a one year term unless you have a more reasonable lawyer, lol.
    Land Titles Office says it is submitted on a Form C (the same one used for easements) and they call it a Right to Purchase.

    • Thanks Lois, for pointing out something I didn’t mention nor has anyone else. Agreements for Sale (rent-to-own) should always be registered on title. That way, an unscrupulous landlord/seller cannot turn around and sell the property to somebody else, and take all your payments with him/her. A prospective buyer would see your agreement for sale on the title of the property and would be unable to proceed with the purchase except subject to your right to purchase the property at the end of your agreement’s term. Please note that rules may vary in other jurisdictions, but our Torrens land registry system in British Columbia works this way.

      Thanks for reading and commenting.

      -Tim

      • aes047

        I was wondering, if you register an AFS on the title to the property does that also protect the buyer in such unfortunate circumstance as the seller passing away before the transition was completed? I only ask because an elderly man has offered us a rent-to-own and what should happen if he passes…will we lose all of our money when the house is left to his heirs? or will they have to carry out the contract?

  • Are the people renting to own able to hold homeowners insurance on the propperty if a Agreement for sale is registered to this property?
    Otherwise wouldn’t the homeowner get the homes insurance and the renter have to renters insurance for thier belongings?

    • Hi Tammy,

      Thanks for your comment, what a great question. My best guess at this one (I’m not an insurance expert) is that the tenant/buyer would have to get contents insurance like any other rental, and the landlord/seller would insure the home and carry liability insurance like any other landlord. Should there be a loss of the building, well then things get more complicated. An insurance broker would be the place to start, or perhaps a lawyer. Because Agreements for sale are registered on title, this may affect how any insurance proceeds are distributed. I will check into this and post an update.

  • Tran

    I am helping a relative to rent/sell their property. They still have a large mortgage on the house and this is a difficult sale. There are potential tenants who cannot qualify for a mortage. I am considering a rent to own approach with a hope that they would take better care of the place.
    Tammy brought up a good point, can the tenants buy full coverage for the house or the landlord still has to get home insurance? Another question is allocation towards the principle.
    I am curious as to how to determine which portion of the rent would be applied towards the principle if the monthly amount just barely covers the mortgage payment. Are there any set guidelines as acceptable payment calculations or whatever agreement between the 2 parties are what would be acceptable? Any suggestions?

    Tran

  • joy

    I also am curious in a situation if I: the landlord wish to make an agreement with a tenant to rent to own, what guideline would I follow as to which portion of the rent to be applied towards the principle ? and what portion will go towards a down payment for the person renting to own??

    • This is decided between the tenant and the landlord on a case-by-case basis. However, here is a guideline that makes sense to me: Once you’ve agreed on the purchase price and length of the term, you should calculate the amount that the tenant would need for a down payment (5% or more). Then, divide that amount into the number of monthly payments and that should be the portion that goes towards the down payment (comes off the purchase price), and the rest would be rent.

      For example – on a $400,000 house, a buyer would need 5% down to qualify for a mortgage, or $20,000. If you’ve set a 3-year term with the buyer/tenant, that would equal $556 per month (12×3 = 36 months, $20,000 divided by 36 = $555.56). At the end of the term, the buyer will have to finance $380,000. Hopefully, they will be able to get the financing. If property values have increased over the 3-year term, the buyer should be in a good position to get financing. As my article outlines, the risk of not being able to get the required financing at the end of the term is one of the inherent risks to a purchaser of a rent-to-own/agreement for sale property.

      My comments are general advice only and don’t constitute legal or financial advice. For specific advice on an agreement for sale, you’ll always want to talk to an experienced lawyer before drafting any agreements.

  • Lynda

    I am considering a rent to own agreement with some friends that cannot get a mortgage. My property is paid for. If I enter into this, would I be responsible for any repairs or replacements of appliances, furnace, hot water tank etc? OR can I put a stipulation that they be responsible for whatever repairs and replacements are needed and the cost will come off the final payment. That may be a bad idea if they want all new appliances etc., as in the end, I would be the one paying for them right?
    I also want to make it affordable for them, as money is an issue, so is there any limit to the amount of years you can stretch the payments, and with an older home,would that be a wise thing to do?
    Lynda

    • The things that you bring up in your questions are matters of negotiation between the seller/landlord and the buyer/tenant. You will have to come to some sort of agreement with them. What would seem reasonable is that you would be responsible for the systems of the home, such as heating, hot water tank, etc, and they would be responsible for other things that they wanted to buy for the house, like appliances. But, everything is open to negotiation. I’m not sure about the length of time for the rent-to-own agreement – I supposed that is a matter of negotiation also, but consider if you choose to allow a term longer than, say, 5 years, your opportunity cost. That is, how much money are you foregoing by allowing them to pay you a small amount each month as opposed to having the lump sum available to invest in other ventures. Another consideration is house values. If I had rented to own the house I bought six years ago, I’d be making an amazing profit right now if I turned around to sell it, at my landlord/seller’s expense.

      Anyone considering a rent-to-own scheme should seek legal advice as to the procedures, rights and obligations, and consequences of entering into such an agreement. I am not a lawyer, so I can’t give legal advice.

  • Vivian Krieger

    Does a person have to own there house outright before entering into a rent to own agreement? What if there is a mortage on the house?

  • Lissette

    I am considering a rent to own situation on my property. However, the current mortgage payments are high. I would feel terrible asking for more in terms of a downpayment applied to the term. Can this be done? Can the downpayment be waived all together? What is the min. years allowed for a term? Once the deal is done, would I still be making payments to my lender or am I eliminated from the process? Currently, I am not interested in a profit, I simply want to not have to keep paying for a house I am not living in. Selling has been difficult with this market but I have had renter’s inquire about a rent to own situation.
    Also, do I need permission form my lender to do this?
    Thanks,

  • Lissette

    One more thing: If I chose to go with a rent to own with my property, will I have a difficulty in getting another mortgage during the term of the AFS?
    Thanks,

  • jessica

    in a rent to own agreement where there is a basement suite involved; who collects the money from the rental unit?

  • kim

    All the info here is quite interesting but I have one question I cannot find an answer to anywhere. How do you set the purchase price? Since prices have dropped somewhat do you set the purchase price at today’s prices or if you are going to have a 3 year term do you set the price at today’s price plus a value of what you think the house may be worth in 3 years? If a house is worth $200,000.00 now and with an assumed increase of 3% in year 1 is the price of the house set at $206,000.00 if the term is for 1 year?
    Thanks

  • Investor1500

    Hi Kim,

    I have done 2 rent-to-owns (as landlord) and both times I negotiated a certain % increase in the value of the house per year.  I tried to base it on 50% of the projected increase over the term of the RTO.  For example, if a house is worth $400,000 today, and is projected to increase annually by 8% per year, then I charge 4% per year.  on a 2 year term, the renter has the option to buy the house for $432,000.

    There are a number of reasons why investors would do this, contrary to the article’s comments.  For example, you pretty much have a guaranteed buyer for a property in 2-3 years, thereby eliminating much of the closing costs (i.e. realtor fees being the largest).  Plus, it allows me to invest in real estate with only 20% down, so i can do a few RTO’s at a time.  With the non-refundable down payment from the renter, it is a major incentive for the renter to actually follow through and exercise the option to buy, as well as the renter taking good care of the property (it is gonna be theirs after all).  These are just a few examples, and all terms are negotiable.

    This program is really only for people with bad credit and who make decent money and really want to get into the housing market.  If you had good credit, there’d be no point in renting to own, just go to a bank, you’d be way better off.

    • Hi there, thanks for your insight from the landlord perspective – it’s good to have your point of view. I really appreciate the comment!