Basic Rent-to-Own Terms and Definitions to Know

Are you thinking about buying a house, but you don’t have the credit score to get the funds you need to make this big-ticket purchase? At the same time, are you sick of renting an apartment that isn’t yours and will never be yours? It seems like you’re just throwing your rent money out the window every month as you don’t get anything in return for paying to live there.

The good news is there could be a solution to your housing problems and that solution is called rent-to-own.

Maybe you’ve heard of rent-to-own and maybe you haven’t. Even if you’ve heard about it, you may not know a lot about it. In order to learn more about rent-to-own as a housing option, you’ll need to understand some of its most basic terms and definitions first.

Rent-to-Own

Rent-to-own is a legal agreement where you make a commitment to renting a property for a specific amount of time with the intention of purchasing the property before or at the end of the agreement. (1)

Essentially, the beginning of this agreement is a lease where you pay rent to live in a specific home. Once the “lease” is over—or before it’s over!—you have the opportunity to purchase the home you’ve been renting.

This is a great real estate investment for those individuals that need to improve their credit scores so they can be trusted enough by the banks to acquire a loan to purchase the home. A rent-to-own agreement gives them time to implement good budgeting and spending habits into their lives so they can steadily improve their credit scores.

The typical lease aspect of a rent-to-own agreement lasts between one to three years, though this term is negotiable between the parties involved in the deal.

Believe it or not, there are also two types of rent-to-own agreements as well.

Lease-Option Contract

A lease-option contract is one of the two types of rent-to-own agreements. This particular version gives you the right (A.K.A. the option) to buy the home once the lease portion of the agreement is over.

This is the more flexible of the options because you do not have to purchase the home once the lease has ended. If you find you’re really not a fan of the home, the property or the neighborhood, or you’re still having financial issues, you can walk away from the agreement, no questions asked.

The only downside of this option is any money you put into the home to help you purchase it in the future is completely gone if you walk away from the agreement.

Lease-Purchase Contract

A lease-purchase contract is the second of the two types of rent-to-own agreements. With this option, you are required to purchase the home once the lease expires. You do not have the option to walk away from the property if you’re not in love with it or if you can’t afford it.

While the terminations of the two agreements are different, most of both agreements are very similar.

The Option Fee

The option fee—also known as the option money or the option consideration—is the money you pay the seller when you initially sign the rent-to-own contract that will entice and/or require you to purchase the home at the end of the lease. This is not exclusive to the lease-option contract; both types of agreements require you to pay this fee. In a sense, the option fee is similar to a down payment.

This fee is also a one-time, up-front payment and it’s nonrefundable, though it’s negotiable. Typically, the fee amount ranges from 1% to 5% of the total purchase price of the home; keep in mind, this purchase price is not the same as the monthly rent price.

Purchase Price

Speaking of purchase price, this is the money you pay for the house at the end of the day after your lease has expired. The purchase price is actually negotiable in a rent-to-own situation.

You could “lock-in” your purchase price for the property during negotiations. If you choose to do this, once your lease is up, that will be the price you pay for the property. You don’t have to worry about the rate fluctuating at all based on market trends and you have a concrete number to shoot for as you save money to purchase your property. Plus, you may be underpaying for your home if the housing market is trending up.

The downside to locking-in your price is you may be overpaying for you property if the market value of your home is trending down.

On the flip side, in your rent-to-own agreement, you could wait until the lease expires to negotiate a purchase price of the home with the seller based on what the current market trends and home values are at that time.

Deciding on the purchase price later could be a great move if the property decreases in value during your lease, but it could be a terrible move if the value increases during your stay. Either option can essentially be labeled as a gamble because no one can tell what the future holds in the housing market.

Rent Credit

Rent credit is a certain portion of your monthly rent that will be set aside to be put towards the money for the down payment of your home. (2) This is one of the nice things about rent-to-own in general because your rent payments are now helping you build equity into your property before you own it.

The amount of rent credit you pay each month is negotiable and there’s no standard rate. It’s good to keep in mind that your rent credit will most likely cause your “rent” to be higher each month than other rental residences–such as apartments–in your area, but now you’re building equity, so it’s worth the extra money in the long run.

Renewal Terms

If you’re not 100% confident you’ll be where you want to be financially by the time your lease portion of your rent-to-own agreement is up, you’ll want to make negotiating renewal terms top priority before you sign your agreement on the dotted line.

Renewal terms are specific conditions written into your agreement that will allow you to renew your lease if you’re not yet ready to outright purchase your home at the end of the lease. (3)

If you don’t negotiate renewal terms before signing your agreement, you’ll most likely lose all the money you’ve sunk into your home while you’ve been renting there and you’ll be out of the property itself.

Renters’ Insurance

99.99% of the time, it’s required you acquire renters’ insurance for a rent-to-own agreement even though your end goal is to eventually buy the home and become a homeowner. Consequently, you would then need homeowners’ insurance.

Renters’ insurance is defined as, “a group of coverages designed to help protect renters living in a house or apartment.” (4) This group of coverages includes personal property, liability, and additional living expenses.

Personal property is insurance that will cover the cost of fixing and/or replacing your belongings and items if something were to happen to the place you’re renting. These belongings and items include clothes, furniture, electronics, appliances, linens, workout equipment and so on.

Liability is insurance that will cover repairs and/or replacements for someone else’s property if you accidentally damage it on your property. It also covers the medical bills of your guest(s) if they’re accidentally injured on your property and you’re deemed responsible for their injuries.

Additional living expenses is insurance that will cover hotel bills and other types of lodging amenities if the residence you’re renting is severely damaged and/or left uninhabitable so you’re left without a roof over your head.

Keep in mind, all three of these portions of your renters’ insurance policy do have a maximum limit when it comes to costs. This maximum amount all depends on the type of policy you have.

Home Maintenance

Merriam-Webster Dictionary (5) defines maintenance as, “The act of keeping property in good condition by making repairs, correcting problems,” etc.

When you’re living in an apartment, you’re responsible for keeping your living space in good conditions while the apartment complex keeps the outside grounds in shape as well as the mechanical features in the building like plumbing, electrical, etc. But when you’re living in a home, you’re responsible for keeping everything about the home in good condition, not just your living space.

Each rent-to-own agreement is different, so it’s important to read what the seller will maintain for you while you’re living on their property and what you’ll be responsible for maintaining.

Typically in a rent-to-own situation, the seller will remain responsible for financial maintenance in terms of fees like property taxes and Homeowners Association (HOA) fees. Otherwise, you’ll most likely be in charge of maintaining the property itself like mowing the lawn, watering plants in the landscaping, cleaning the gutters on the house, raking leaves in the fall, shoveling the driveway in the winter, unclogging drains in and around the home, repairing any holes in walls, painting the walls, etc.

Mortgage

Once the lease portion of your rent-to-own agreement has expired, you’ll need a mortgage in order to purchase the property.

A mortgage is defined as a legal agreement between you—the borrower—and a lender—your bank, a financial institution, etc.—to allow you to buy a home without having all your own cash on-hand at the point of purchase (6). It should be noted that you don’t necessarily need a mortgage if you do somehow find yourself with all the money on-hand to purchase a property; having the funds up-front to buy a property outright is just a very rare occurrence.

Your newly acquired mortgage also establishes the amount of money you must pay the lender back for the loan each month. If you don’t meet the minimum monthly payments, the lender can legally repossess the property and take it away from you.

A mortgage payment is made up of primarily two parts: the principal and the interest. Keep in mind though, the mortgage payment can also include taxes and homeowners’ and/or mortgage insurance fees.

Principal

The principal portion of a mortgage is the amount of money you’ve borrowed up-front to purchase your home (7). For example, if you have a $50,000 saved for a down payment on your rent-to-own property but the purchase price of the house is $250,000, you’ll need to borrow $200,000. The $200,000 is the principal of your mortgage.

Interest

The interest portion of a mortgage is the money you pay your lender in exchange for providing you with the loan to purchase your property (7). It’s based on a predetermined percentage rate when you initially apply for the mortgage.

Mortgages are typically structured to last for 30 years, though you can pay off a mortgage faster than that. At the beginning of your mortgage, when you owe the most principal, most of your monthly payment goes to paying off the calculated interest. As the years go by, your mortgage payment will go to paying off less interest and more principal.

Currently in the US, mortgage interest rates are averaging between 3.70% to just above 3.80% (8). What determines interest rates? The APR.

APR

The annual percentage rate (APR) is the actual amount of interest you pay on your loan per year (7). The lower you can get your rate to be, the better as your monthly payments will be lower. Higher rates will cause your monthly payments to be higher. In general, the APR fluctuates based on the housing market and the economy. Typically though, once you receive your mortgage, your APR will stay the same unless you decide to refinance.

There’s so much more that goes into rent-to-own agreements, but these terms and definitions should help you get a better, basic understanding on how these agreements work.