Is rent-to-own the solution if you can’t get a mortgage?

Click to play video: 'Money 123: Understanding rent-to-own'
Money 123: Understanding rent-to-own
WATCH: Homeownership can be a pipe dream for some Canadians. So what can tenants do if they want to buy the home they're already living in? Erica Alini takes a look at how renting-to-own works – Sep 22, 2018

Most Canadians probably haven’t heard about rent-to-own housing. Unlike the U.S., this arrangement is pretty rare in Canada.

But that may soon change, as rising interest rates and tighter housing rules make it harder to qualify for a mortgage.

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Rent-to-own is an alternative route to homeownership for those who can’t obtain financing due to poor credit or because they don’t have enough money for a down payment (or both).

The idea is that you rent a home for a certain period of time with the goal of buying the property at the end of your lease.

If all goes according to plan, by then you’ll have repaired your credit and/or saved enough to secure a mortgage.

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How rent-to-own works

Rent-to-own agreements, also called lease-option agreements, can take many different forms.

Buying the house

Some rent-to-own agreements give the tenant the option to buy the house at the end of the lease. This is sometimes set out as a commitment. You must buy the house or you’ll be in breach of the agreement.

Future purchase price

The future price of the house is generally locked in, but some contracts are based on the future appraised value of the house at the end of the lease, which usually lasts one to three years.

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WATCH: Here’s how rent-to-own agreements work

Click to play video: 'Money 123: Understanding rent-to-own'
Money 123: Understanding rent-to-own

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Initial fee

Tenants usually pay an initial fee equal to two to four per cent of the agreed purchase price. From the landlord’s point of view, this ensures that the tenant has skin in the game and is motivated to actually buy the property at the end of the lease.

The fee is usually treated as part of the tenant’s future down payment or as a sum that will be discounted from the final sale price.

The fee may be fully or partially refundable. Often, though, you lose that money if you don’t go through with the purchase.

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Additional payments

In addition to your rent, you’ll also have to make regular payments that help to beef up your down payment or add to your eventual discount on the home price.

The landlord won’t necessarily charge you lower rent because of this.

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Maintenance and repairs

Unlike regular tenants, you’ll often be responsible for carrying the cost of home maintenance and repairs.

Landlords and investors

Sometimes you’ll deal with a landlord who hopes to sell their property. Other times, your counterpart is a real estate investor or group of investors who bought the house with the intent of using it for a rent-to-own arrangement.

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How one real estate investor pitches rent-to-own to both tenant-buyers and investors

Rent-to-own likely makes the most sense for families with a bruised credit record who want to own a home and have a pretty clear idea of where they want to live, money expert and real estate investor Limor Markman told Global News.

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Markman runs a business that connects tenant-buyers with real estate investors through agreements that she describes as a win-win.

The way Markman structures the deal, tenants can choose the houses they want to live in. That allows families, for example, to pick properties in coveted school districts, she said.

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Locking in the purchase price also allows buyers to work toward down payments without having to worry about runaway home prices, she added.

Having to make monthly payments to grow that down payment amounts to a “forced savings program,” she said. Markman also pairs up her tenants with mortgage brokers who specialize in credit repair.

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Markman’s tenants also usually pay rent that’s slightly higher than market rates, but they also enjoy “the privilege of living in a home today that [they’re] going to own in the future.”
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And while they must also pay for maintenance and repairs, they can hang pictures and paint the walls whatever colours they like. If they want to, say, renovate the kitchen counter, Markman and her investors will likely approve that, too.

Tenants will lose any equity they built into the house if they fail to eventually purchase the property, but that’s laid out clearly in the rent-to-own agreement, Markman told Global News.

At the other end of the deal, investors make money through guaranteed home price appreciation, the equity paydown and the fact that they’re paid slightly higher rent, Markman said.

And unlike regular landlords, they don’t have to worry about matters such as broken furnaces and leaky roofs.

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Potential pitfalls

Canadians thinking about a rent-to-own path should do so with their eyes wide open, said Jason Heath, managing director at Thornhill, Ont.-based Objective Financial Partners, a fee-only financial planning firm.

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The math

“It all boils down to the math,” Heath told Global News. Once you’ve taken rent, maintenance and repairs into account, “is this a better option than just renting and then buying a different property?”

Doug Hoyes, a licensed insolvency trustee and co-founder of Hoyes, Michalos and Associates, had similar advice.

“I am not a fan of most rent-to-own deals, because you end up paying a premium,” he told Global News.

I would advise anyone to wade into this with an abundance of caution and be sure to look at the numbers. Look past the monthly ‘rent.’  Look at the interest rate – how much equity are you building in the initial years? What happens if you lose your job – you may have lost even more.”

The advantage of locking in a purchase price disappears if home prices stagnate or start falling, Heath added.

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Getting a mortgage

One of the major risks of rent-to-own agreements is that the tenant will not qualify for a mortgage at the end of the lease, according to Melanie McLister, co-founder and mortgage broker at intelliMortgage.

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“If they do not qualify, [they are] at a significant risk of losing any sweat equity or savings they may have put into the home,” McLister told Global News via email.
And, she added, “some put in a considerable amount of both, feeling confident the home will be theirs in the end.”
Buyers should keep in mind that it’s becoming increasingly difficult to qualify for a mortgage due to the stress test and tighter rules that were introduced recently.
Finally, she said, rent-to-own contracts “are often not drawn up in a manner that the banks feel comfortable with.”
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For example, some lenders McLister works with require agreements that tenants receive at least a partial refund if they do not exercise their right to purchase. They will likely not deal with a tenant-homebuyer who has signed a contract that does not follow these guidelines, she said.
“This limits the new buyers’ lender options when it comes time for them to get the mortgage,” she noted.
“An inexperienced landlord, not realizing how important the original agreement is, may not prepare the rent-to-own contract in the new buyers’ best interests and therefore could inadvertently jeopardize the financing options down the road.”
Another possibility is that you’ll qualify for a mortgage but you won’t like the terms of your loan.
“Rates could go up, the payments [could be] more than [you were] expecting. It would be hard to walk away from a large, non-refundable deposit as well as any other money [you] might have invested into the property while living in it,” McLister said.
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She recommended obtaining legal advice before signing a rent-to-own contract to ensure that you understand the risks completely.

“Obviously if things go well, everyone is happy. If they don’t, my concern would be lawsuits, reputation risk and headaches,” McLister said.

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