People are usually confused when trying to determine the difference between sale on contract and rent-to-own residential property. Buying a home on a contract is often referred to as owner-financing. Selling a home on a rent-to-own basis is often called purchase-leases or lease-options sales. Both of these may seem similar at first but, in reality, are quite different in several aspects.
Transfer of Ownership
Contract sale: The buyer takes possession of the residential property and the seller is the lien holder. So, instead of going through a mortgage lender, the property is owner financed. The buyer makes payments to the seller, on a monthly basis, until the loan is paid in full.
Rent-to-own: The tenant makes payments for the amount of time specified in the contract, usually three to five years, until he or she can obtain financing from a lender or until they are able to pay the seller for the property. For example, a homeowner rents his or her residential property for $1500/mo but negotiates a rent-to-own contract where the buyer agrees to pay $1750/mo. A home-buying credit of $250/mo is held by the home owner. By the end of a three-year lease, the buyer would have $9,000 accrued towards the purchase price of the home. At that time, the $9000 is returned to the buyer, who can use it for an earnest-money deposit, down payment or closing costs.
Who pays for home repairs and maintenance?
Sale on Contract: With a sale on contract, the buyer is the legal owner of the residential property and is responsible for all repairs, maintenance, insurance and taxes.
Rent-to-own: With rent-to-own, the tenant is essentially renting or leasing the property until they obtain financing to purchase the home. In this case, the homeowner is responsible for all repairs, maintenance, insurance and taxes. The tenant/buyer should obtain renters insurance to cover their belonging.
In both situations, the buyer’s payments ultimately result in an increase in home equity. With a sale on contract, the seller amortizes the buyer’s monthly payment just like a traditional lending institution would do. A portion of each payment goes toward the interest and the rest on principal.
In a typical rent-to-own agreement, a portion of the tenant’s monthly payment is set aside to be used towards the down payment. When the tenant obtains financing, the amount of the down payment becomes instant equity in the home.
Pros and Cons for a Rent-to-Own Property
Aside from the obvious benefit of having time to build up a down payment and improve their credit standing, renters have the benefit of testing out the home and community before buying. The tenant also has the ability to lock in the sale price and terms of the purchase upfront, allowing the tenant to purchase the home at below market value in a few years. The down-side is if the tenant decides not to buy, any money paid towards the purchase is not refundable and the owner has to go through the process again with another tenant.
Pros and Cons of an Owner-Financed Transaction
The seller benefits from a quicker transaction and the receipt of payments and interest over a long period of time. There is some tax advantage for the seller, but they will have to pay taxes on income generated by the loan in the form of interest. With owner financing, the seller runs the risk of a buyer defaulting on the loan. If this happens, the seller must begin foreclosure actions, which can be costly and time-consuming.
Tips for Negotiating a Sale-on-Contract Transaction
The seller should be diligent in obtaining a full credit history on the buyers and ask the buyers questions until they are confident the buyer is able to fulfill their part of the contract. The seller should request a written explanation of any negative entries on their credit report. I can’t stress this enough!
The buyer should obtain a current local housing market report and hire someone to inspect the property so they may be confident that the home is priced fairly and there are no major problems with the home.
The seller should include proof-of-payment clauses in the contract, requiring the buyer to provide proof of payments for insurance and taxes.
An owner-financed transaction can be beneficial for both seller and buyer, if both buyer and seller do whatever is necessary to reduce their risks.