What is The Difference Between Rent To Own And Contract For Deed?
For home buyers who are learning what rent to own and contract for deed are for the first time it can be confusing to understand the differences between these two real estate contracts.
Is Contract for Deed the Same as Rent to Own?
These two types of real estate contracts are polar opposites of each other. A rent to own is still a tenant/landlord relationship that is a lease agreement, whereas a contract for deed allows a buyer to purchase a property and take ownership.
Since a rent to own (or referred to as lease option) is still a lease agreement, there is not many benefits to the renter compared to a contract for deed that has all the advantages of homeownership.
Rent to Own Vs Contract for Deed
Rent To Own
Rent to own is also known as: lease option, lease-to-own, option-to-purchase, rent with option to buy, etc. As the name would suggest, a tenant is renting the home with the intent to purchase it within a predetermined time-line (usually 1 to 3 years).
In a lease agreement credit matters very much as there will be an application fee where the landlord/property management company pulls credit. It is therefore important for tenants with credit issues to find out the landlord’s qualification criteria as early in the process as possible.
The option part of the rental agreement is ultimately what makes it a rent to own, because the landlord and tenant agree to a purchase price upfront when signing the lease agreement.
For example, a tenant signs a lease agreement on a home they love with the landlord and agree upon a purchase price of $200,000. At any time within the lease agreement the tenant can purchase the home at this pre-determined price; typically once they are able to get financed by a bank.
The obvious benefit here for the tenant is they are locking in today’s home prices for something they plan on buying in the future. If home prices rise they are gaining equity in the home. On the other hand, if home values decrease the tenant does not need to move forward with the purchase. The tenant is able to avoid being “upside down” on the home and move on.
A rent to own also is a way for the tenant to reserve the house. During their lease agreement the landlord can not sell the home to anyone else. On the downside, it does lock the renter into the specific property when there could be more desirable houses available; especially if they find problems with the home once they start living in it.
As discussed below there will potentially be consequences if the tenant is not able to purchase the home by the end of their lease agreement. Besides purchase price, the following are additional terms that the landlord may or may not choose to include in the option section of a rent to own agreement.
- Option Down Payment – Instead of taking a security deposit and one month’s rent seen in a typical lease; a landlord may choose to ask for a non-refundable down payment ranging from 3-5% of the purchase price. This is to give the landlord security since the intent is to purchase the home (and the main reason landlords agree to do a rent to own versus a normal lease). As long as the tenant purchases the home this down payment will go towards their financing, otherwise the landlord will keep it when the tenant moves out.
- Monthly Rent Credit – A monthly rent credit is where a percentage of the tenant’s rent is credited towards down payment as an example. The catch? The rent credit is almost always above market rent. For example, if the normal market rent for a house is $1600/month the landlord will simply raise the rent to $1750/month allowing a rent credit back to the tenant of $150/month. In other words, there is virtually no benefit to the renter of having a rent credit unless they rent stays at market rates. It should also be noted the landlord will still keep the rent credit during the lease agreement, and if the tenant fails to exercise their option to purchase the home landlord gets to keep everything.
- Home Maintenance Responsibilities – Tenants in a rent to own agreement should be aware that most likely they will take on minor home maintenance responsibilities since the intent is still to eventually purchase the home. Outside yard work and fixing leaky toiles are some examples. However, major structural items such as a roof should not be part of this as the landlord will be carrying homeowner insurance on the property. Make sure to read the fine print in the rental agreement to ensure there are no misunderstandings down the road.
Contract for Deed: Who Owns The Property?
Now that you understand what a rent to own contract is we can compare the differences with contract for deed financing, and in many ways these two real estate contracts could not be more opposites.
Unlike a rent to own where it is a tenant/landlord relationship, with contract for deed you own the property through a purchase. As the owner you will pay property taxes, homeowner insurance, and have full responsibility of the property maintenance. Instead of going to the bank for a home mortgage the seller will finance you, or sometimes it is called owner financing.
Additional differences between rent to own and contract for deed:
- Down Payment – Since contract for deed is a purchase instead of a rental there will be a down payment, which ranges between 10-20% of the purchase price.
- Credit Does Not Matter – One of the primary reasons contract for deed has a higher down payment requirement is because credit plays no factor in qualifying for a loan. It is a major difference versus rent to own since many home buyers have credit challenges that may disqualify them otherwise.
- Monthly Payment – Similar to a bank mortgage the buyer in a contract for deed will have a term loan. This includes a interest rate over a length of time. For example, a 30yr. loan where principal & interest payments are made on a monthly basis. For home buyers who are tired of throwing money away on rent this can be an appealing difference versus rent to own as principal is paid down on the loan every month. Also, in many areas around the Twin Cities, Minnesota area rental rates are higher than what your monthly payment will be with contract for deed financing.
- Balloon Payment – A rent to own will have a lease period versus contract for deed that has a balloon payment, which is a way for the owner to set a date on when they want the borrower to refinance into a bank mortgage. A rent to own may have a shorter lease period (1 to 3 years) whereas a contract for deed is typically longer (3 to 5 years).
- Home Remodeling – What about projects like a kitchen or bath remodel? With contract for deed there are no limitations since you own the home versus rent to own that is still a tenant/landlord relationship. A tenant in a rent to own contract will not be allowed to do anything materially to the property then.
- The Property can be sold at profit – If the buyer in a contract for deed is unable to obtain bank financing they can always sell the property at a profit assuming a rise in the home’s value. On the other hand, in a rent to own the tenant has no other option but to walk away if they are unable to get bank financing losing everything.
- Tax Advantages – With contract for deed, just like bank financing, the buyer is able to deduct interest paid on the loan along with property taxes when they file their tax return. As a tenant in rent to own there are no tax advantages.
A rent to own is mainly a lease agreement versus contract for deed that is a purchase. Thus, the majority of individuals will choose contract for deed as home ownership has many advantages over renting.
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