What Are The Differences 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.
For these are the only two alternative methods to purchase real estate for home buyers who cannot obtain bank financing. There are more exotic financing options for investors and non-owner occupied home buyers, but if you are simply trying to purchase a home as your primary residence rent to own and contract for deed financing are it.
Rent To Own
Rent to own financing is also known as: lease option, lease-to-own, option-to-purchase, rent with option to buy, etc. As the name would suggest, you are renting the home with the intent to purchase it within a predetermined time-line (usually 1 to 3 years).
Virtually 95% of the contract is still going to be a standard lease agreement renters are accustomed to in Minnesota. This does mean 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 willl 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 like you would see in a typical lease; a landlord may choose to ask for a non-refundable down payment ranging from 3 to 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 either the purchase price or down payment (tenant chooses). For example, out of $1600/month rent $150 shall be considered a credit. The landlord will still retain this during the lease agreement, and if the tenant fails to exercise their option to purchase the home landlord gets to keep the rent credit.
- 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
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.
First and foremost, with contract for deed you are purchasing the home. Make no mistake about it: you are the owner of property, 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 there will be a down payment, which ranges upwards to 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 – Just like a bank mortgage the borrower 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 limitiations 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 may be sold – In a worst case scenario, the borrower in a contract for deed can always sell the property to hopefully recoup their down payment and principal paid on the loan (and potentially even profit if home prices have risen). 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 by the end if their lease agreement.
- Tax Advantages – With contract for deed, just like bank financing, the borrower 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.
The clear message with both of these real estate contracts is they are meant to only be short term solutions until bank financing is an option. Home buyers need to understand this going in, and make sure they are constantly working with mortgage lenders/credit restoration companies to ensure they can get eventual bank financing.
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. To learn more about the differences between Rent to Own and Contract for Deed, view the following table below.
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