If you are like me and follow every property/real estate/HGTV type Facebook/Instagram/Twitter page there is going then you have no doubt seen a lot of posts creeping into the online world lately regarding Rent To Own. So let's uncover what it is, and how it works - buckle up - this blog is long...
First off, there are many reasons why a purchaser does not qualify for a regular mortgage and it is not always because they have bad credit, although that is one of the most common reasons.
Whatever the reason, there are seemingly more and more people looking for RTO products in the current housing market. Buyers want to get in while the prices are low but are also struggling to fit into the mold of the current mortgage rules and where there is a will, there is always a way.
For starters, Rent To Own is entirely legal - but that does not mean that all RTO contracts are created equally. In Canada, there are very basic guidelines that govern how RTO contracts are drawn up meaning that for every good RTO company out there, there is about 50 more predatory ones to watch for as well.
Although there are not accurately kept statistics available, one RTO firm suggested that the average success rate of contracts they administered was only 40-50%. A second firm which operates a much closer credit counselling service from start to finish said they had a 97% success rate. As well as the massive variation on the types of companies that offer these services, there are also huge variations on how they draw up the contracts. If you are interested in this process at all you will want to research every company out there, ensure you understand all of the risks and of course, speak to your favorite lawyer and mortgage broker.
How does it work? In a nutshell...
- Purchase price is established in advance and a contract is drawn up for a purchase of the property after a set period of time (usually 2 - 3 years)
- You pay a set up fee anywhere from 2 - 4% of the agreed upon purchase price
- You make the agreed upon rent payment each month during the 2 - 3 years. Your agreed upon rent will be higher than normal rent and will include a payment that goes towards your down payment (generally you will be saving the minimum 5% down payment and the purchase at the end will then be insured by CMHC)
- The down payment is saved in a separate bank account that you do not have access to, if you qualify for a mortgage on your own and are able to complete the purchase this down payment is paid to the seller along with the remainder of the funds from the mortgage you obtain.
- You work on whatever the criteria was you needed to meet in order to qualify for a regular mortgage (credit score, employment tenure, 2 year history etc.)
- You are solely responsible for the home during this time - repairs, furnace/hot water tank, plumbing or electrical issues, roof repairs etc. This is not your typical rental and your landlord does not cover these items while you are living there under the contract. Keep in mind you will not be on the title of the property during this time.
- Upon completion of the RTO term, you obtain your own mortgage from a regular lender, use the saved down payment to put towards the purchase and the home is yours.
Where does it fail? In a nutshell...
- Purchase price when established 2 - 3 years before the contract is completed may catch some buyers out. An appraisal from a lender will likely be done at the time of applying for a mortgage and if the property no longer appraises as high as the purchase contract was for, then the buyer will need to come up with the difference or risk losing it all.
- You pay a set up fee - (a 2% set up fee on a $300,000 purchase price is $6,000) That is a lot of money to pay to someone which you could have used towards a down payment 2 years down the road if you had just waited and saved your money. That fee is occasionally rolled into the down payment amount with generous companies but often it is lost as an administration cost.
- Rent payments are much higher than normal market rent costs. Yes, a portion of this is to put towards savings of your down payment. However, another portion of this is to compensate the owner for taking the risk.
- There are no rules governing how much of your down payment you will get back in the event the deal collapses. Each contract is different and if you are unable to complete the purchase or qualify for a mortgage at the end of the term you may lose this down payment savings entirely. The law dictates that 'some' of the down payment must be returned - but how much is up to the seller or RTO company.
- You may not be able to remedy the criteria that you needed to fix in the time allowed. Credit re-builds often take longer than expected. Jobs can be lost, wages decreased, divorce, illness or other unexpected issues that could mean that by the end of the term you still don't qualify for a mortgage on the property. Even if all of that works out, interest rates or the government lending rules could change as well meaning that the home you thought you could afford 3 years ago you no longer qualify for under new rules.
- You are responsible for the home during your tenancy - so you could be putting massive amounts of money and time into repairing or fixing up a property that you may not be able to purchase in the end.
- If the initial contracts and program is not set up correctly, you may not be able to qualify for a mortgage simply due to the improper paperwork. For example, the bank account for the down payment needs to be established properly, a rental market analysis needs to be conducted prior to the contract being drawn up, CMHC needs to be on board with the plan as they will be insuring the purchase when you put a minimum down payment on at purchase time. There are also limited lenders who will accept RTO buy outs which means you might not be able to hop into your local bank - and you may be subjected to whatever interest rates you can get due to those circumstances.
Risk Vs Reward
Both buyers and sellers take on varying levels of risk in this transaction. For the sellers, they take on the risk that the buyers do not complete the purchase and leave the house requiring repair work that costs more than the amount of the saved down payment. Similar to a rental unit where the owners may only have a damage deposit to cover repairs, however, in a rental unit the landlord is still able to check in on the property and make repairs as needed to ensure the taps don't burst.
Sellers with their own mortgage on the property also run the risk of buyers not paying them on time or being left with a property that is not worth as much as they owe on it if property value decreases. Sellers may also be paying interest on their new mortgage for their new home while the equity they could have used as down payment is tied up in the RTO property for a few years which in turn will cost them as well.
Ultimately, sellers must be willing to take the risk that they are entering into a contract with buyers who the bank doesn't think is a good candidate to lend money to. And the bank likes lending money to people. As brokers, we handle poor credit, inconsistent income, borrowed down payments, co-signers and all kinds of roadblocks to help get people approved so if they don't fit into any of our lenders then I would be hesitant to suggest they should fit in with you. There are also legal fees for drawing up these contracts and if you choose to use a RTO company as an intermediary then you will be paying an administration fee to them as well to facilitate on your behalf.
The reward end of things for the seller however, could be fruitful. Consistent rent payments for 2-3 years plus a sale on the home after that time. Or the return of the property which they can sell again if the buyers were unable to fulfill the purchase - and should the market increase then perhaps even a sale at a higher price. Assumption of the lost down payment savings if the buyers were unable to purchase as well as the 2 - 4% set up fee.
For the buyers the risks are far greater. In a failed contract the buyer essentially loses everything. The home they thought was theirs, all or most of the saved down payment, the set up fee, lawyer fees, and any money they put into the property essentially putting them back to square one with no savings and nothing to show for their last few years worth of effort.
And even if the deal does go through, the buyer is paying CMHC insurance fees, the set up fee for the RTO, the premium on the rental rate, higher legal fees, the possibility of higher interest rates from a lender who will take on the buy-out and the possibility that the property they bought is worth less than the agreed purchase price 2 - 3 years prior.
The Bottom Line
Risk tolerance varies from person to person and whether this is a fit for you or not, is entirely up to you. I am not an expert in Rent to Own and there are obviously always success cases where this has worked well. That said, my personal preference would be that all sellers can sell their homes without needing this option and all buyers can work with their favorite mortgage broker to establish a plan that ensures they will be ready to buy down the road without the restriction of a looming deadline and the massive amounts of stress that come along with it.
Set up a monthly savings plan and goal to save the down payment, we can also look at flex down borrowed down payment options. Lets work out a plan to re-build credit, we can look at B lenders for short term lending if they don't quite qualify at an A lender.
There are many options we can explore while buyers are preparing to purchase that does not end in the possibility of losing all their savings and sets them up for a successful home purchase when they are ready.
As always, if you have any questions about this topic or anything else mortgage related feel free to give me a call at 780-720-4034.