Compare Rent-to-Own Vs. Mortgage: What's the Best Option for You?

By Chika

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Last Updated: October 21, 2021

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Having a home is a basic necessity and usually considered to be an important milestone in one’s life.

There are two routes that prospective homeowners can take to achieve their dream goal. They can either take out a mortgage or rent-to-own. Both options, though geared towards home ownership, come with benefits and demerits.

This article takes a comparative look at both options so that you can decide what's the best way for you.

 

What is Rent-to-own?

A rent-to-own contract is one in which you commit to renting a property for a certain period with the option of buying it before the lease expires. With this option, you pay higher than the fair market value, which is usually 1% of the agreed-upon price for the home. 

That extra amount is used as a down-payment for the home at the end of the lease, regardless of whether the tenant chooses to own the property or not at the end of the lease.

However, if the tenant chooses not to buy the property, (s)he loses the extra payments. Rent-to-own contracts usually consists of two parts: a home rental lease agreement and an option to buy.

Rent-to-own contracts come with a timeframe in which the tenant is expected to switch from renting to buying the house. This is usually at a year from when the agreement was signed, and no more than two to three years after the initial agreement.

 

What is a Mortgage?

A mortgage is a loan that is used to buy a home or real estate property.

The borrower takes out a loan from a loan service provider and then pays them over a period of time. The purchased home is used as collateral for the home. As such, if the borrower defaults, he may lose his home. 

Mortgages are usually spread for as much as 30 years, though they have 15-year and 5-year mortgages. Interest rates payable on a mortgage are determined by the benchmark interest rate set by the Federal Reserve.

The interest rate may be fixed, which means the borrower pays the same interest during the tenor, or they may be adjustable, which implies the interest rate stays fixed for some period, before it is adjusted to reflect prevailing interest rates.

 

3 Differences Between Rent-to-own and Mortgage

1. Funding

The difference between a rent-to-own option and a mortgage is how the house payments are funded.

A rent-to-own is like a down payment on a house, whereby a series of payments are made towards owning the house in the future. A mortgage, on the other hand, is akin to owning the house now and paying for it later.

2. Tenor

There are also differences in the time frame of the agreements.

Rent-to-own schemes usually have a short tenor (about 3 years) for the buyer to own the home. However, mortgages usually have a longer tenor for the borrower.

3. Interest rates

There is also the question of interest rates. While interest is paid on mortgages, rent-to-own does not have interest rates.

 

Rent-to-own vs Mortgages

Let's compare and contrast both options for owning a home.

Economic cycles

Rent-to-own options usually have a fixed price, which is based on the market value of the home at the time the agreement was entered.

So, if the tenant signs the lease agreement during a recession, their home equity can rise when the economy recovers, thereby giving them substantial gains. On the flip side, if they sign the lease agreement during an economic boom, they may see the value of their home equity deteriorate during recessions.

This is unlike a mortgage, whereby as the economy grows and interest rates rise, you typically pay more on your mortgage, and when the economy slows and interest rates drop, you pay less. As such, mortgages tend to track economic cycles more closely than rent-to-own options.

Credit score

Rent-to-own agreements are a viable option for those with a poor credit score which is an important factor lenders consider to determine your eligibility for a mortgage. If you do not have a good credit score, you would not be able to access a loan to purchase your home.

This is unlike a mortgage option, where what is needed is your monthly payments.

Home equity

If you have a mortgage, you can tap into your home equity and borrow loans against it. The law allows people to borrow up to 80% of their home equity loan. You can also take out a line of credit (HELOC) which works like a credit card taken against your home equity.

However, with a rent-to-own option, you cannot take out a loan against the home, which is technically not yours until you finalize the lease agreement.

Mortgages can give you the option of raising extra funds to put into profitable ventures or used to settle emergencies. The rent-to-own option leaves you ‘high and dry.’

Control

While a mortgage gives you greater control of your home, the rent-to-own option does not give you control of the home. You can't control what the landlord does during the lease period.

In fact, you may lose your prospective home if the landlord fails to pay their mortgage. As such, you will not be able to do maintenance of improvements on the home, unlike in a mortgage where you have 100% ownership rights.

Cost of entry

It is cheaper to start a rent-to-own process than a mortgage. The latter usually requires down payments of up to 20%.

Raising such capital may be cumbersome for prospective homes. However, with the rent-to-own option, you just need to add the extra cost of 1% of the home’s value to your rent, which is more affordable.

 

What is the Best Option for You?

Usually, most people favor a mortgage over a rent-to-own agreement because the former gives the borrower greater control.

With a mortgage, you have greater control of your home and what you can do with it. You can decide to make some refurbishments and improvements which would increase the value of your home. Even when you decide to relocate you can easily sell your home and move on.

However, with a rent-to-own option, your fate is in the hands of the landlord as you can't control what the landlord does. The landlord may decide to stop making payments which could put the property into foreclosure.

You may also not have a say on the maintenance work done on the house if it does not meet your standard during the process.

Mortgages also give borrowers more options for raising money such as home equity loan or HELOC.

These options are not available in a rent-to-own scheme whereby a default could see you losing your deposits. You also have limited options if you want to follow the rent-to-on route.

If you want to live in a particular neighborhood, it can be quite a challenge finding a landlord who offers rent-to-own. However, with a mortgage, there is no shortage of options when it comes to neighborhood and house type.

Read this next: The Top Benefits & Drawbacks of Fixed Rate vs.. Adjustable Rate Mortgages

 

Final Word

Prospective buyers need to know the risks involved when they decide to purchase their home. A home is a financial asset,. But it also encompasses our personality and the quality of life we intend to live.

It usually sets the pace of how we raise our family and how we interpret our existential realities. 

Owning a home through a mortgage gives greater control over the home. It also provides an extra source of credit which comes in handy during emergencies or if we want to take advantage of investment opportunities. 

You may not be able to access a mortgage now due to a bad credit score. But you can use that three years of a rent-to-own scheme to build a better one. The right mortgage lets you buy your dream home without being subject to the limitations and risks that come with rent-to-own contracts.

Photo by Andres Ayrton from Pexels

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