Once upon a> time would-be home buyers could easily secure a mortgage, even with less-than-stellar credit or little money to their names. Although such buyers are largely cut out of today's market, "rent with the option to buy" listings offer them an opportunity but not without some risk.
More sellers and home builders are now considering rent-to-buy offers in the struggling real estate market, especially in new developments and areas where prices are deflated, says Stuart Gabriel, director of the Ziman Center for Real Estate at the University of California, Los Angeles. That broadens the pool of potential buyers to people who might not qualify for a mortgage in the current credit crisis from first-timers who lack enough for the down payment to veteran owners recovering from a foreclosure, short sale or other financial crisis.
Here's how rent-to-buy deals work: The seller agrees to rent out the property for a set period of time (typically about two years) giving the renter the option to buy before that time runs out. A portion of the monthly rent goes into an escrow account to be used as part of the down payment should the renter decide to exercise his purchase option. But there's a catch: If the renter decides to walk away, he forfeits that money.
Just as important, don't mistake a listing that changes to rent-to-buy from a straight sale as a sign of seller desperation, warns Chuck Whitehead, president of Coldwell Banker Real Estate in Temecula Valley, Calif. Although that switch could indicate a last-ditch effort to move the property, sellers can benefit from rent-to-buy agreements more than buyers. Not only can the seller lock in a price before real estate values plunge further, but he also collects market-rate rent until the closing. That can add an extra 5% to 10% to the seller's take, Whitehead estimates.
Despite the potential pitfalls, rent-to-own real estate is still a buyer's market. Today the buyer can set the terms to whatever they want, says Edward A. Mermelstein, a New York-based real estate attorney. You're looking to be as creative as possible.
Here's what you need to know before you seal the rent-to-buy deal:
Research neighborhood prices
Making a rent-to-buy agreement in an area where real estate values are still dropping such as New York City is risky business, warns Gabriel. That's because you're negotiating the purchase price and closing costs for a property now that you may not actually buy for more than a year. That could easily result in overbidding. The monthly rent should also be on par for the market. Factor current prices for comparable homes in the neighborhood and projections for the region into any offer you make.
Leverage down-payment funds
Many sellers ask for a so-called option consideration fee, an amount of 1% to 5% of the home purchase price paid upfront and held in escrow until closing. If you're absolutely certain you want the home, agreeing to a bigger option consideration fee can help you negotiate a lower monthly rent, says Mermelstein. Just remember that it is nonrefundable should you walk away from the deal.
Bring in help
Read our story, 10 Mistakes First-Time Home Buyers Make
Assess your creditworthiness
Getting a mortgage these days is practically impossible without a credit score of at least 720 and > a 10% down payment. Buyers opting for rent-to-own must be confident that they can meet both qualifications to secure financing by the end of the rental agreement. Otherwise they chance losing everything in that escrow account, says Gabriel. Assess how much you need to improve your financial picture, and then talk to a financial advisor or credit counselor about whether that's doable within the rental period. You can also negotiate for a longer rental period to ensure you have enough time, says Whitehead.