Buying a home is one of the biggest and most expensive investments you will make over the course of your life. So what happens if you can’t afford to get onto the property ladder? Should you look at a rent-to-own situation instead? Probably not; there are some real down-sides to a failed rent-to-own situation.
What is a rent-to-own?
A rent-to-own situation (an “RTO”) is when you want to buy a home, but can’t quite qualify for the mortgage that you would need in order to buy that home outright.
As the potential buyer, you say to the seller “I’ll buy this home from you at $[price]. I’ll do that by paying you $[amount] each month for [x years] (usually 3-5 years), and at the end of that time, I’ll pay you the rest of the money I owe you for the home”.
The idea is that, by the end of the agreement’s term, you’ll finally be able to qualify for that mortgage you need. This is a dangerous gamble, and not one to be undertaken lightly. RTOs are rare for a reason. They usually only happen when:
- a buyer is desperate to have a particular home, and the seller can’t find anyone else to buy it outright; or
- a seller is experienced enough to set the RTO up in such a way as to ensure a guaranteed return from it; or
- a seller has priced a particular home too high for most buyers, and a buyer has fallen in love with the home despite the too-high price.
If not done right, RTO agreements are a legal and financial disaster waiting to happen.
RTO agreements are legally binding contracts, and if you do not carry out your end of the contract, you can be subject to significant penalties and costs. RTO agreements have to be carefully drafted, and since they’re unusual agreements, not everyone can draft them properly. You really should use a specialist REALTOR®, BC Notary or lawyer to draft them for you.
RTO agreements play out over a longer period of time, and have a fair amount of complexity around things like payment of taxes, utilities, insurance, strata fees (if any) and other ongoing expenses or maintenance.
For example, the seller may be required to continue paying their own property insurance, but the buyer has to reimburse the seller for this insurance coverage. But you, as the buyer, don’t get to pick what kind of insurance coverage the seller will get, or where they will get it. So you’re stuck with whatever policy the seller gets.
What’s in it for the seller?
Very little, to be honest.
Sellers are only going to enter into RTOs for properties that they can’t sell easily, or where they have a buyer who is willing to pay more for the property over time in an RTO scheme than a regular buyer would. Much depends on whether the seller is actually trying to sell the property, or whether they are willing to use the property as a form of long-term investment.
For example, if a seller truly wants to be rid of the property, they are unlikely to want to enter into an RTO agreement – if the market is hot, they can just as easily find a buyer who is ready, willing and able, with no strings. If the market is less hot, they may just simply lower the price or make other accommodations. As a motivated seller, wouldn’t you rather have a buyer who you knew was going to go through with the transaction, right away, with no worries about financing or complex agreements about who will pay what for the next 5 years? If you’re selling, you just want out. You don’t want to keep being tied to this property for another 3-5 years.
Some sellers will consider RTOs as a form of investment – they are willing to enter into them, but only because they have crafted their agreement to cover all of their costs over the course of the agreement, and to pay them enough money over the course of the term to make it worth their while. This is great for the seller, but far more expensive for the buyer in the long run. These sellers have to be willing to hold onto the property for this time frame, and they have to be willing to accept the possibility that the buyer will fail to carry through their part of the bargain.
What’s in it for the buyer?
The big draw in an RTO situation for the buyer is the possibility that they will own their dream home – this specific dream home – at the end of the term, for an agreed upon price.
Buyers often think of it like buying a home on lay-away. Put a little down now, and pay the rest over time. Unfortunately, that’s not really an accurate metaphor.
You put a deposit down now, and you pay money over time, but you will never be able to structure the deal to pay all of the remaining funds over time – the price will simply be too high. Instead, you will pay an agreed upon amount for a term of 3-5 years and when the term is over, you need to find financing to pay the rest of the money owed.
What are the downsides for the seller?
Because the buyer isn’t paying the seller the full amount of the sale price right away, the seller has to keep paying their mortgage over the course of the RTO’s term. The mortgage will still be registered on title, and the seller will still be obligated to pay it. The amount the buyer pays each month will cover this (and other expenses), but what happens when the buyer fails to make a payment? The seller still has to pay their mortgage, no matter what.
In a well-drafted RTO agreement, the buyer will have to cover the seller’s costs for dealing with a missed payment – including interest, late payment fees and penalties.
What happens if the buyer fails to carry through on the RTO agreement when the term is over? The terms of the RTO agreement may or may not specify penalties or costs. If the buyer has put money into repairs, have those repairs been authorized? Have they improved the property? Does the seller need to reimburse the buyer for those repairs? What happens if the buyer has damaged the property, or put a grow-op into it? How does the seller get possession of the property back?
What are the potential drawbacks for the buyer?
There are a host of serious potential drawbacks for a buyer in an RTO scheme.
One common argument buyers make in favour of an RTO agreement is “if I were to buy this place in 5 years, the purchase price would be so much higher that I might not be able to afford it…. If I lock in the purchase price now, then I’ll really be getting a great deal over time.” This is not great logic.
You cannot guarantee what will happen with house prices over time. Yes, in bigger markets like Vancouver, the prices are generally going to go up (not necessarily consistently, but they generally go up). But that’s not the case in other markets. There could be significant drops in housing prices in other markets over time. You need to research the way in which house prices behave in your community to know if this is a factor for you.
You can’t guarantee what will happen with the property over time either. There are many things that could devalue the home over time, such as major repairs, structural problems, or legal issues with rights of way, easements or other charges registered on title to the property. If you’ve agreed to pay a particular price for the property, but there are major issues with it that devalue it, you are still stuck with that agreed-upon purchase price.
Nor can you guarantee what will happen in the seller’s life that could affect this transaction. Since the seller still remains on title, you are still potentially affected by their risk. If the seller gets divorced, their spouse may be able to put a charge on the property that could interfere with the seller’s ability to complete this transaction. If the seller gets into financial trouble, their creditors or trustees-in-bankruptcy could make claims against this property. While those claims might not necessarily stop the RTO transaction from happening, they would certainly make things more difficult.
If you can’t afford that mortgage now, what makes you think you’ll be able to afford it in 3-5 years? Things can change significantly over a 3-5 year period. What makes you think you will still have the same job? That you’ll still be living in this community? That your family life will be the same? Marriages, divorces, births, deaths, job changes…. You can guarantee none of these things, and each of them can lead to a failed RTO agreement.
RTOs are also expensive for the buyer to set up. Buyers have to pay property transfer tax at the time they register their interest in the property. They also have to pay legal fees to register their interest in the property at the Land Title Office. Buyers also have to pay legal fees again when they go to pay out the final amounts, and register the property completely in their names. So their costs are significantly higher than a standard purchase.
So, should you do it?
As a buyer, if you can’t afford a mortgage for the property you are hoping to buy, that’s a fairly important signal for you to listen to.
In Canada, we have very strict qualification rules that are meant to ensure that buyers don’t get themselves into a situation where they can’t afford to keep paying their mortgage. No one wants a borrower to end up in default. A mortgage should never be entered into lightly, and only if you can truly afford to pay it over time. Your mortgage broker will help you determine the amount of mortgage you can afford. Listen carefully to their advice.
Remember that when you enter into a mortgage, you are personally promising that you will pay that mortgage off, no matter what happens. You can’t simply walk away from a mortgage you can no longer afford.
A buyer often has to take a step down in location or quality in order to move from a rental situation to an owned property, and buyers can be tempted to go into an RTO situation because they feel like they can get more “house” for their money. That may be true in the short term, but it doesn’t mean the buyer will be able to carry through on the purchase when the term is over. If they couldn’t afford it now, what is going to change that means they will be able to afford it in 3-5 years’ time? If there isn’t a clear answer to this, then you shouldn’t enter into an RTO.