Most Common Rent-to-Own Mistakes
Rent to own is a raw deal for tenant-buyers, many real estate and personal finance pros say. The balance of power is tipped too far in favor of the landlord-owner. Time is not on the tenant’s side. And too many other things can go wrong with the deal in general, leaving renters homeless (in a worst-case scenario).
Here are the biggest pitfalls of renting to own that you, as a prospective tenant-buyer, could encounter on the path to home ownership.
1. An Unclear Title
You’ve probably learned that before you sign any real-estate contract, you need to make sure the landlord-owner has clear certificate of title to the property, meaning that no one else can claim a right to it. If another individual – say, an ex-spouse – has an ownership interest, the seller will have trouble transferring title if you decide to buy. If the landlord-owner has a mortgage, home-equity loan or home equity line of credit (HELOC) on the property, the bank has a claim to it that will have to be satisfied before you can take over. The same is true if the landlord-owner has unpaid property taxes or income taxes and a tax lien has been filed against the property.
So far, standard stuff. The special problem in this case is that, even if the landlord owns the house outright and the property has a clear title when you sign a rent-to-own contract on March 1, the title could become encumbered on March 2 or at any point thereafter. (See Encumbrances And Nonpossessory Interests In Real Property.) If that happens, you won’t be able to close on the house unless the owner pays off the debt, and no contract you sign can guarantee he or she will follow through on any promise to do so. At best, you might be able to include provisions in the contract that gives you recourse if this happens. For example, the contract could say that the landlord-owner will return your security deposit and rent credit (an addition on your monthly rent, which goes towards the purchase price) if a cloudy title prevents you from exercising your option to purchase within a certain time period.
2. Expensive Home Repairs
Normally, you wouldn’t do a home inspection on a property you were going to rent. The inspection costs several hundred dollars, and the landlord is fully responsible for the cost and logistics of completing any repairs. You’d simply take a careful look at everything and maybe complete an inspection checklist documenting the unit’s condition with your landlord before you moved in.
In a rent-to-own situation, you need to get a home inspection before you even start renting. It’s a useless, extra expense to pay the monthly rent credit and/or an upfront option deposit for a place that needs additional, considerable investment to bring it up to par. Not only do you not want the expense and hassle of the repairs, but lenders won’t give you a mortgage for a home that’s in poor condition. They want collateral that’s actually worth the money they’re going to lend you to buy it.
Home inspections can’t tell you everything and sometimes even miss major things, but it’s worth getting a professional to try to spot expensive problems or problems waiting to happen. (To learn more, read Do You Need A Home Inspection?.)
3. A Financially Shaky Seller
The property isn’t the only thing that needs inspecting. Because of the unusual and complex nature of rent-to-own transactions and the ability of the seller’s financial problems to affect you, it’s important to do a financial background check on him or her before you even start renting. If the seller is not willing to go through this process, that’s a potentially bad sign.
Veteran real estate agent Wendy Patton, author of “Rent-to-Own: How to Find Rent-to-Own Homes NOW While Rebuilding Your Credit,” recommends that tenant-buyers ask the seller to sign an “authorization to release” letter, which allows you to get information directly from the seller’s mortgage company or lender. Patton also recommends hiring a title search company or attorney to make sure the title is not encumbered and asking the seller to provide you with copies of personal credit reports. Poor credit could indicate financial trouble. If the seller goes bankrupt, you probably won’t be able to complete the purchase.
4. Sloppy Contracts
Letting the seller provide the rent-to-own contract is one of the most common mistakes tenants make, says Elysia Stobbe, Jacksonville, Fla. branch manager for NFM Lending and author of “How to Get Approved for the Best Mortgage Without Sticking a Fork in Your Eye.” “Typically, the person who writes the contact has the most power in a negotiation,” she notes. “The seller can put in all the terms they want, and the buyer gets stuck either accepting them or trying to change them.”
Also, most buyers and sellers have no idea what needs to be included in the sales contract to be legitimate in the eyes of a mortgage lender’s underwriter, which could put the entire deal, and any of the buyer’s earnest money (like the option fee and the rent credits), at risk. From a lender’s perspective, “there must be either a lump sum deposit for the down payment or the monthly rent must be above the market average, with the difference going into an escrow account towards the down payment,” Stobbe says. “A combination of both is also acceptable.”
If you don’t want to take the initiative in writing the contract, you should at least hire your own real estate attorney to review it. He or she can point out clauses that aren’t in your favor and help you negotiate a more fair agreement. Another option might be to start with a do-it-yourself rent-to-own contract, available online for a few dollars, then work with an attorney to customize it. Since real estate laws vary by state, Stobbe says buyers should be sure to work with an attorney in the same locality as the property.
5. Avoiding Escrow (Services)
The rent-to-own universe is rife with predatory landlords who have no intention of ever selling their property, and who are just trying to collect above-market rent and eventually make off with your nonrefundable option deposit. For protection, you should use an escrow service. This neutral third party acts as a financial intermediary between you and the landlord. It will hold your option deposit and monthly rent credits until you buy the property, at which point it’ll return the money to you to put toward your down payment and closing costs. If the purchase option expires and you decide not to buy, the escrow service will remit those sums to the landlord. It will also turn over the money to the correct party in the event that either of you violates your end of the agreement in a way that can’t be remedied. (Learn more in Who manages an escrow account?)
It’s not just for your protection: Banks and mortgage lenders like to see that the money is in an escrow account, Stobbe notes. It ensures they won’t go to the work of qualifying you for a loan and underwriting it, only to have an unethical landlord refuse to return the funds and prevent you from closing.