Rent-to-Own and Seller-Financing… Who has the upper hand?

Renting To Own and Seller Financing are 2 things that get thrown around a lot. Most people who offer these options don’t have a full understanding of what’s involved. Both renting to own and seller financing are extremely advantageous to the seller/owner, however, given the right circumstances, they can be beneficial to a buyer/renter. Regardless of which side you’re on, it’s important to understand the positives and negatives of these 2 options.

Let’s cover Rent-to-Own first, then hit Seller Financing.

Rent-To-Own

Many people think this is something you can do when you’re renting a home that you want to buy. This is true, but it’s not as simple as stating “hey we want to rent your home and also may want to buy it later.” There’s a lot of risk and sacrifice that fall on the shoulders of the tenant/buyer. There are 4 reasons that make this option disadvantageous to tenant/buyer, and the same 4 reasons that it’s advantageous for an owner/seller.

  • Risk. In a true rent-to-own deal, the tenant needs to agree on a purchase price at the time they sign the rent-to-own lease. You do not have the option to renegotiate this price. Typically the purchase will occur after 1 year lease, or any time during the lease. This is a risky situation simply because we cannot predict the future. The market could crash, and if you still wanted to buy the home, then you have to pay the price you agreed on… a year ago!!

 

  • Over Pay. In a rent-to-own situation you really need to convince the owner to give you this option to buy their home. They don’t get to change their mind later; the option to buy is the tenant’s. In order for them to consider a rent-to-own, especially due to the aforementioned unpredictability of the future, you will most likely need to agree to at least full market value, but probably above market value price.

 

  • Unnecessary Cost. A rent-to-own agreement is a special privilege given to the renter/buyer, therefore, you need to pay for that option to buy. This can be done in one lump sum or monthly in addition to rent. This additional money will go towards the purchase of the home should you decide to buy it. Usually the total amount should add up to what would be a normal down payment. This is all negotiable, so sellers can demand however much they want; that in itself is a bad reason to do a rent to own. I’d advise to my sellers that they at least receive what will be the future down payment for the home at the agreed purchase price. To put this in perspective, the minimum down payment is 3.5%… For example, a 300k home would cost an additional 875/mo… or a deposit/fee of 10,500. Sometimes owners will demand more. So… we’re not talking about a small amount of money here. Most people who tell me they’re willing to do a rent-to-own would probably second guess themselves if they knew the cost associated with doing so.

 

  • More Risk. Due to number 1, 2, and 3. In most cases a person trying to do a rent-to-own cannot buy right now, otherwise they would have already done so. Circling back to predicting the future…not only is the market unpredictable, you can’t really predict your ability to buy either. Job change/loss, salary change, commute change, debt:income ratio change, etc. All of these things go into your ability to get a mortgage, and may change your desire to purchase the property. IF… IF you cannot buy the home, all the additional money that you’ve paid, is kept by the owner. Could you imagine spending $10k all year, only to find out that because interest rates went up you cannot afford to buy the house? Or… spending even more, and finding out that you’re getting transferred to another office 50 miles away? In addition to the unpredictability of life, consider my second point about paying full market value or over market value… the home may not appraise at that price, and you won’t be approved for a loan… resulting in… Bueller? Bueller? Losing the additional money you paid for the option to buy.

There’s a lot of risk and sacrifice that fall on the shoulders of the tenant/buyer.

All of these factors simply add up to a disproportionate increased level of risk, which doesn’t make sense. If you’re desperate, it would be better for you to offer all these things 60 days prior to your lease being up, and incentivize the seller at that point in time, as opposed to a year or two prior.

The only time this can help is if you are in high competition, and you have the money and risk to take. OR if you can get very good terms. i.e. a minimal deposit/fee or monthly increase and a price that you feel is below market.

Now…

Seller Financing

This is when the seller become the buyer’s bank. This is a little more beneficial to buyers than the rent-to-own situation. It comes with a sacrifice, but it’s typically worth it. Sometimes the bank is not willing to take on the risk of giving a mortgage to someone. This could be for several reasons, but the underlying reason is that they don’t trust that they’ll pay their mortgage for one reason or another (DTI Ratios, credit, etc.), and then the bank would have to go through a lengthy foreclosure process; meanwhile deal with a deteriorating home. This process is a little different for a seller/owner that does seller financing, however.

The seller can name the terms for the financing situation. Usually they’ll charge a much higher interest rate than a bank would. Furthermore, they’ll require at least 20% down. From the seller’s point of view, they’ll be getting a lump sum of 20%… back to our $300k example, that’s $60k. Also, they’ll be making interest… probably somewhere between 5%-7% but again, this is all negotiable; some sellers may not feel comfortable unless they receive 30% down payment or 10% interest. Nonetheless, despite how advantageous this is for the seller, the buyer would NOT be able to buy a home otherwise, so if you really want a home and cannot get approval for a mortgage, then you could try to see if a seller would consider seller financing.

The next advantage to a seller in regards to seller financing is the avoidance of a long foreclosure process. In place of “foreclosing” on their buyer like a bank would, they can exhaust an eviction process. Evictions, if done correctly, can be done in 4-8 months. The seller will be allowed to kick the buyers out relatively quickly, keep the down payment and whatever interest they’ve made up to this point, and do it again. It’d actually be pretty sweet to get 60k twice in one year for 1 property wouldn’t it???

Again, this one is actually a little less lop-sided. Sellers get a lump sum of money, an above market interest rate, and have an easier process than a bank to reclaim the asset, but the buyer gets to buy a home, which otherwise wouldn’t have been possible.

I know this was a quick one. I had to get this out there for you! Whether you’re a renter, buyer, or owner, let me know if you’d like to talk further about these options.

Comments and questions are welcomed!

Thank you for reading!!!

Best,

Joe

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