By Allison Martin

Are you in need of a new home but can’t get approved for a mortgage? Whether you’re short on funds to make a down payment, have a low credit score, or your debt-to-income (DTI) ratio is too high, you might have to explore other options, like a rent-to-own agreement, to purchase a home. This arrangement could work if you’re serious about owning a home and can afford the rent payments. However, rent-to-own agreements also come with drawbacks.

How does rent-to-own work?

A rent-to-own agreement allows you to rent a home and purchase it at the end of the lease term. When you sign on the line, you agree to occupy the property as a tenant for a set time, typically one to three years. 

“Renters get the option to ‘test drive the house’ without having to buy if it isn’t the right fit,” says Peggie McQueen, a real estate agent with Dalton Wade Real Estate Group in St. Petersburg, Florida.

Here’s where rent-to-own differs from a traditional rental agreement: You’ll also have the option or obligation to buy the home under certain conditions. As part of the arrangement, the landlord takes a portion of your rent payment or a rent credit and deposits it into an escrow account. These funds can later be used towards the down payment if you purchase the home. 

Types of rent-to-own arrangements

  • Lease option: This arrangement allows you to negotiate the purchase price at the end of the lease. When you sign the contract, you’ll also pay an option fee of typically between 2 percent and 7 percent of the purchase price. These funds will go toward the purchase price if you decide to buy the home — but you’ll lose the rent credits and option fee if you walk away. “There’s no way to time the market,” McQueen says. “If you decide to buy the home at the end of your lease, you could walk into the deal with equity. You could also find that it has declined in value over the lease term, and the deal won’t make much sense at that point.”
  • Lease purchase: This contract legally obligates you to buy the home and specifies the property’s purchase price. You’ll forfeit any rent credit and possibly be subject to a lawsuit for breach of contract if you decide to back out of the deal. 

Rent-to-own vs. buying a home

A rent-to-own home could be sensible if you need time to get finances in order, know where you want to live, and intend to buy a home. However, buying a home might be the better move if you’ve already found the right home in the perfect area and qualify for a mortgage with competitive terms. 

Rent-to-own pros and cons

Pros

  • You’ll have time to prepare your finances for a mortgage and can work directly with a lender to ensure you’re ready when the time comes. 
  • You could potentially be living in your dream home, even though you’re renting it, which prevents another buyer from purchasing it when the lease ends. 
  • If you’re in a lease option-arrangement, you’re not obligated to buy the home when the lease expires. 
  • You can get a feel for what it’s like to be a homeowner without committing to a mortgage right away. 

Cons

  • You’ll forfeit any premiums paid on your rent if you decide not to purchase the home or can’t get approved for financing. 
  • You could fall in love with the home and be forced to walk away if you enter into a lease-option agreement and the home’s value significantly increases or declines. 
  • You could be sued if you breach a lease-purchase agreement. 

Is rent-to-own right for you?

It depends on how committed you are to becoming a homeowner. A rent-to-own agreement could give you time to sort out your finances, save up for a down payment and improve your credit score. 

“Ultimately, it boils down to personal preference,” McQueen says. “If I have a prospective buyer who’s serious about buying a home but struggling to get approved due to credit or income issues, a rent-to-own home could be a good fit. However, they must be willing to do the work to make their dreams of homeownership a reality.”

If you’re still on the fence about buying a home, it might make sense to hold off on a rent-to-own arrangement. Otherwise, you could lose the monthly premiums you paid over the lease term if you decide not to purchase the home or can’t get approved for a mortgage. 

This article is also posted on Bankrate here.