Purchasing a Home with a Rent to Own Contract
More importantly, how to take the proper steps to ensure you get credit for built up down-payment funds.
A typical scenario for a “rent to own” property is this: An investor purchases a home, probably one that will need some TLC, and probably for cash, then puts some resources into it to get it to marketable condition. That investor may have a tough time selling the property right away and will then market the property as rent to own, and will usually get great responses.
Why would an Investor offer Rent-to-Own?
You might wonder why an investor would want to market a home to people that would otherwise be unable to purchase a home? There is one main reason. It is that in a slower real estate market, like the one in which we currently find ourselves, properties are taking longer to sell and the holding costs for an empty property are quite high and usually hard to insure.
Why would a Buyer Rent-to-Own?
You’re a first time home buyer/shopper who wants to own a home but, you don’t quite qualify just yet. Maybe you were out of work and are now getting back on your feet, maybe you just switched careers. The most common issue a buyer would face is a lack of necessary down payment funds.
Perhaps you have had some credit challenges and are going through some type of credit restoration to improve their scores.
The Federal Housing Administration or FHA, does allow for rent to own contracts, however, FHA Guidelines are very strict on how the payments are made and received, explained below.
How a Rent-to-Own Works
Upon entering a rent to own contract, a buyer will typically give the investor a modest deposit. Perhaps equal to 2-3 months of what a mortgage payment would be. This is usually non-refundable if you don’t hold your end of the deal. A deposit on the line will give you some “skin in the game” and maintain your motivation to actually buy the property when the day comes.
In addition to normal rental payments, you will be depositing some money with the seller each month that you will use as a down-payment to take possession of the home at the end of the contract.
You will enter into a contract that states:
-The specified and actual rental payments the landlord is planning to keep as income.
-The agreed upon amount the renter will pay in “overage” that will eventually go towards your down-payment on the mortgage.
-The term of the contract or the specified date that you have to perform on buying the property.
-The purchase price aspect will either be determined at inception of the contract or it will be agreed that an appraisal will be completed at the end of the term and that will be the agreed price.
-The bank account info, banking institution and account number where the “overage” will be held.
Plus all the other statutory rental legal stuff.
The Devil is in the Details
So, here is an example:
You have agreed to rent the property for a period of two years and the landlord needs to keep $1,000 per month as rental income.
You have agreed to purchase the property at the end of the rental period for $200,000 or the current market value, whichever is less.
To consummate the agreement you gave the landlord a $1,500 deposit that will go towards your down payment and the total down will be $7,000 (per your lender).
Over the next two years, you will need to pay $5,500 in “overage payments” that the seller will escrow for you to meet down-payment requirements (difference between $1,500 and $7,000).
This means that in order to execute the purchase at the end of the 2 years, you will need to have paid $229.17 in “overage” each month ($229.17 x 24 months = $5,500).
Here is where most people, landlord sellers and rent-to-own buyers usually blow it.
Do not pay the landlord each month with one check that amounts to $1,229.17.
Do not ever pay anything with cash, ever.
Do not allow the landlord to co-mingle the rent and the overage in one bank account.
Do not ever pay the rent or overage late.
Do not ever skip either rent or overage…ever.
Do- Pay the landlord each month TWO SEPARATE CHECKS, one for the rent = $1,000 and one for the overage = $229.17.
Do- Pay by check always.
Do- Ask for a copy of the statement of the separate bank account account that your overage is being held in, every six months, even quarterly, if you would be more comfortable.
Do- Keep a detailed record of all payments you make, either by keeping the bank statements showing the checks clearing or preferably by keeping each and every cancelled check that clears your account.
Do- Keep detailed records of any improvements you make to the property while you are renting.
Do- Pay all your other bills on time.
Keep Records and Get it in Writing
You want the landlord/seller to know that you are keeping detailed records. Never assume that a verbal agreement will suffice.
You should ask that these stipulations be added to the rent-to-own contract before signing it:
-That you will be paying in two separate checks.
-That the overage account must be a separate interest bearing account and he/she cannot touch the overage or move it without notifying you and getting your approval.
-That your overage deposit must be kept in that account as well.
-That the seller must provide you with quarterly or semi-annual statements from that account.
-That you cannot pay any items in cash, you will need a solid paper trail of all moneys.
-That you cannot skip any payments during the term, even in exchange for home improvements.
[caption id="attachment_1483" align="fltlft" width="308" caption="Keep detailed records from the start..."][/caption]
All of these records will need to be submitted to the lender as part of your credit and underwriting package. This will be your responsibility, not the landlord’s.
These payments will in essence and quite literally be, how the underwriter assesses your credit history over the last two years.
In order to get credit for that overage and use it as your down-payment, you must have a SOLID paper trail of rent payments and overage deposits.
If you miss a rental payment or an overage deposit you will be marked as being late, even if both parties were to agree to the skipped payment.
TRAP TO WATCH OUT FOR:
The roof leaks and the landlord puts in a claim with his insurance company. The damages are $900 and the landlord says “just skip your rent this month and make the fixes yourself or with your own contractor”. No, this will not be track-able and it will cause the underwriter to mark you as late that month.
Be absolutely sure that everyone in the household who has access to make payments from the checkbook or out of a bank account is aware of these potential pitfalls.
Why Such Detail?
As mentioned above this will be a huge portion of your credit history when you go to qualify to buy the house, it will not be on your credit report and there is no other way to verify your history by the underwriter.
Also, it used to be a very easy way for a landlord to generate some income on a property and sell it quick. They would manufacture a rent-to-own contract and have both parties backdate it. This is fraud and it used to happen all the time. Lending guidelines surrounding rent to own deals had to become incredibly strict over these few bad apples.
Follow these simple steps and you won’t be met with a big surprise when it comes time to execute on your end of the deal and….buy your first home!
If you are a potential home buyer that perhaps has some type of challenge that prevents you from purchasing a home right now, you may want to look into rent to own properties. It will offer you a way to become a home owner sooner than you think.
And as always have your attorney look at any document that you sign with regard to any type of real estate transaction.
If you have questions about any of this, please feel free to give us a call here at Poli mortgage and we would be glad to answer them for you.