What is Rent-to-Own?
Rent-to-own (also known as Rent-to-Buy) is a well-established method of becoming a home-owner in Australia. It’s a strategy that suits a certain sub-section of buyers, such as those traditionally not eligible for
financing.
There are advantages and disadvantages,
as well as certain risks to both the buyer
and the seller, and independent legal advice
is always recommended.
The Rent-to-Own strategy offers a practical solution for gradually saving up a deposit whilst locking in the purchase price, as long as you are in the Agreement period and you adhere to the terms and conditions. In real estate terms, Rent-to-Own is an agreement where a tenant rents a property with an option to buy at a future date when the lease expires.
The Agreement.
A rent-to-own agreement is actually two contracts… there’s a tenancy agreement, and an Option to Purchase agreement. At the beginning of the lease, an agreed-upon term is established, at the end of which the option to purchase the home is
given to the tenant.
The amount of rent is typically higher than the market rent, as a portion of the rent is used to go towards building the deposit towards the purchase of the home at the end of the lease term. The “extra rent” is usually 20-40% more. For example, a normal rent of $500 per week might be $700 per week in a Rent-to-Own deal, with the extra $200 going towards the deposit that is being gradually accumulated.
At the end of the lease term, there is a time called the 'option period' where the tenant can purchase the home by taking a home loan out with a bank or a typical lender.
Here’s the big risk: If the tenant is unable to purchase the home at this time, they lose all contributions and equity established and it is essential that before you sign on for a rent-to-buy scheme, you are confident you will be able to both make the higher rental payments and be able to purchase the property at the end of the lease.
The Time Frames.
The time frame for a Rent-to-Own deal is usually 2 to 5 years. Before entering such an agreement, the purchaser must be pre-qualified by a mortgage broker. The pre-qualification will determine if the payments are affordable and if the purchaser is likely to qualify for a home loan when the time comes to finally own the house (together with the bank which has provided the funds to buy it).
In a typical Rent to Own, the aim is that the purchaser will build up a 10-20% equity in the property to qualify for a home loan at the end of the term. The equity can be built up by the extra payments, by renovations and sometimes by increases in property values.
If there is insufficient equity at the end of the rental term of 2 to 5 years, a Carry- Back Loan can be used to bridge the gap between the deposit that has been accumulated, and the home loan available.
Why Rent-to-Own?
If you can buy a property using traditional methods, then it’s usually better to do so. You have sufficient deposit, you’ve been pre-approved for the finance, so find a property you like and start negotiating.
The Rent-to-Own strategy works best for those that are unable to qualify for a traditional loan. It works well for first-home buyers struggling to secure a deposit for a home loan. It’s also beneficial to people who want to improve their credit score so they can qualify for a mortgage.
Further, there are many people who have been discharged from bankruptcy but are unable to qualify for a mortgage, even though they are totally back on track, financially.
Sole traders and self-employed people often have difficulty demonstrating sufficient income to qualify for regular finance. This problem can be overcome with a larger deposit which can be created over time through a rent-to-own purchase.
You need to be aware however, that you probably have little room for negotiation on these kinds of deals. The seller holds most of the cards…. If you don’t want to accept his selling price and his terms, then someone else will. There are usually more potential buyers than sellers in Rent-to-Own arrangements, so if the deal looks good and you’ve ticked all the boxes (more on this below), then its best to put pen to pen before someone else beats you to the punch.
Advantages of rent-to-own
Benefits include:
- Lower upfront costs: In a normal purchase situation, the Buyer needs a large deposit… to avoid Lender’s Mortgage Insurance, a 20% deposit is required. A smaller deposit will still work but be prepared to pay a small fortune in LMI. Even so, the very minimum deposit required is 5%. With Rent to Own, the deposit is usually 2- 2.5%.
- Opportunity for credit repair: If you have a bad credit rating or a low credit score, or you’re a discharged bankrupt, a rent-to-own scheme can help repair this by the time you apply for a mortgage.
- Locking in the purchase price: Part of the contract locks in the purchase price of the property before you move in. Even if the price of real estate continues to go up (which it has a habit of doing), you are insulated against that as you’ve already agreed to a purchase price in the Option agreement.
- Try Before you Buy : In a rent-to-buy arrangement, you can live in the property you may want to own with no obligation to buy at the end of the lease, if you feel that it isn’t really what you want. Your Purchase Option gives you the right but not the obligation to proceed, and you can just walk away if you want to (after the rental agreement has elapsed).
What you need to know before entering a Rent-to- Own agreement
- Understanding the contract: Understand the figures and understand how much of your rental payment is going towards the deposit. Don’t enter this kind of agreement (or any agreement) unless and until you know the figures. Again, it’s recommended that you get independent legal advice before proceeding.
- Potential risks: The biggest risk is that you are unable to exercise the Option to Purchase at the end of the rental period because you cannot get a bank loan. In that instance you lose all the equity you've paid towards your house during your lease.
- Maintenance responsibilities: In a normal lease, the owner is responsible for repairs and maintenance. For a rent-to-own scheme, the tenant is often responsible for maintenance. It’s also usually the case that the tenant is responsible for the outgoings, such as rates and insurance (and body corporate fees if applicable). These expenses need to be factored as all part of understanding the figures.
- Market conditions: Real estate prices usually go up over time, and this is one of the benefits of this kind of deal because the purchase price is locked in. However, understand that markets can fluctuate, and real estate prices can and do sometimes go down.Again, if you are unable or unwilling to proceed after the rental agreement period, you won't get any of the money refunded to you. Just like a normal rental agreement, what you’ve paid has been paid and that’s that.At the end of the lease, during the option to buy phase, there will be fees involved with getting a home loan, legal fees for contracts and such, just like a normal house purchase. This is all part of understanding the figures.
Note: Rent-to-Own is not suitable for use for properties in Victoria or South Australia.