Every so often I have a client who does not qualify for a standard mortgage and will look at a rent to own as a potential option. Though I only have limited involvement in these transactions until the very end, I do try to educate my clients on the process and potential risks involved so they can make an informed decision.
The most common reasons for not qualifying would be that they either do not yet have a down payment OR perhaps credit issues that need some work before qualifying.
The property owner and the tenant will come to an agreement on the purchase price and the contracts are usually set up with the tenant paying an initial deposit and a premium on regular monthly rent. For example, if market rent should be $1200 per month the client may pay $1600. The additional $400 per month is typically held in a trust account for the term of the rent to own contract, say 3 years. After the 3 years is up the cash in the trust account can be used for their down payment upon qualifying for a mortgage.
What could possibly go wrong?
Property Value Issues: If at the end of the term the value of the property is not at least equal to the original agreed upon purchase price – the banks may not finance the home. For example, if the contract sets the price at 300K and values drop within the 3 years to 280K the client will now need both a minimum 5% down payment on the 280K value AS WELL as an extra 20K to make up for the value discrepancy. Appraisals are almost always required on ‘rent to own’ homes and this is the biggest issue I have seen over the last few years.
Qualifying Issues: Again, at the 3 year mark the tenant will have to qualify to buy the home. Mortgage rules are constantly changing so a buyer who qualifies based on today’s guidelines may not qualify in 3 years time. If the tenant happens to develop some credit issues within the 3 year contract or lose their jobs/take a pay cut ,they may not qualify to get a mortgage at all. Most rent to own contracts are based on 5% down payments at the end of the term. With less than a 20% down payment in the trust account – the mortgage default insurers (CMHC / Genworth / CG) have to approve the buyers , property and contract as well as the lender.
Owner Defaults: What kind of protection does the tenant have if the current owner of the home stops paying his mortgage or property taxes? Usually NONE. If the current owner stops paying the bank the property could be foreclosed upon while the tenant is occupying the property and fulfilling their end of the bargain.
What does the tenant have to lose? Often these contracts are drawn up in favor of the owner, not the tenant. If the tenant misses a rent payment or does not qualify at the end of the rent to own contract the tenant may lose some or all of their deposit and down payment in trust.
What should one do if considering a rent to own property? ALWAYS seek legal advice. Do not use the seller’s lawyer, It may cost you extra to have your own lawyer review the contract but it is important to have your own representation. Also, speak with a mortgage professional in advance. You will want to ensure that after the rent to own term is up that you have the best chance possible at qualifying for a mortgage.