The perilous path of rent-to-own

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  By Guest Blogger Sinan Terzioglu

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The journey to homeownership is often challenging, particularly for those with poor credit or insufficient down payments. This has led Canadians to increasingly explore innovative options like rent-to-own agreements, which allow potential buyers to rent a property for a specified term with the option to purchase it later. While rent-to-own might appear to be an ideal solution, these agreements often come with significant risks and challenges that can lead to substantial financial losses, making them advisable to avoid for most people.

Rent-to-own arrangements resemble traditional rental agreements, where tenants pay monthly rent to the landlord. However, the rent is generally 10-20% above the market rate because it includes a portion called rent credit. The rent credit is set aside to contribute towards the future down payment of the agreed-upon purchase price of the property. If the tenant decides not to buy the property at the end of the rental term, usually lasting 1-3 years, they forfeit all the accumulated rent credits.

Additionally, rent-to-own arrangements require applicants to pay an upfront fee called the option deposit. This deposit grants the option, but not the obligation, to purchase the property. It typically ranges from 3% to 5% of the property’s agreed-upon purchase price, which is usually higher than current market values to account for anticipated appreciation. If the tenant decides to buy the property, the option deposit is applied towards the purchase price. However, if the tenant chooses not to purchase the property or cannot secure a mortgage at the end of the rental term, the option deposit, in addition to the rent credits, is forfeited.

In addition to the higher costs, one of the biggest disadvantages of rent-to-own agreements is that tenants do not have the legal rights of homeowners during the rental term, but are often still responsible for all repairs, taxes, and insurance. If, while covering all these recurring costs, the tenant misses or fails to make a single lease payment, the option to purchase the property can become automatically null and void, and the option deposit will be kept by the owner/seller as “liquidated damages.”

Another drawback is that tenants often have no control over the landlord’s actions during the rental period. The landlord could decide to sell the property to someone else, default on the mortgage, or face foreclosure. If the property had issues before entering the agreement or encounters legal problems affecting its value or title, tenants may be at risk of having to cover unexpected costs to preserve their opportunity to purchase the property and avoid losing their option deposit and rent credits.

Example

John, a 35-year-old, has experienced financial setbacks over the years, but he is now earning $75,000 annually, has repaid his debts, and has accumulated $25,000 in his TFSA. Although he currently does not qualify for a mortgage, he is eager to purchase a property within the next few years, fearing that if he doesn’t act soon, he may be priced out of the market permanently.

John finds a property listed for $500,000 and is considering entering a rent-to-own agreement. The monthly rent for a similar property is $2,500, and John has been presented with the following rent-to-own agreement:

Rental Term: 3 years
Agreed upon purchase price in 3 years: $538,445 ($500,000 current price with 2.50% annual price appreciation)
Option deposit: $16,153 (3% of agreed upon purchase price of $538,445)
Monthly rent including rent credits: $2,875 ($375 rent credit per month)

At the end of the 3-year rental term, if John decides to buy the property with a 5% down payment, his option deposit and rent credits will total $29,653 and cover his down payment so he will need to qualify for a mortgage of approximately $509,000, calculated as follows: $538,445 purchase price minus $16,153 option deposit and $13,500 rent credits.

Even before accounting for property taxes, insurance, and maintenance, the monthly mortgage payment for a $509,000 mortgage amortized over 25 years at 4.25% would be approximately $2,750. This exceeds the 39% limit of gross income that lenders generally prefer for total housing costs. Additionally, finding a lender willing to finance a rent-to-own agreement can be challenging, as some lenders may not accept rent credits as part of the down payment or may impose higher interest rates and stricter underwriting standards. Furthermore, with a down payment less than 20%, John would need to obtain mortgage default insurance, which would add upwards of 4% of the mortgage value to his total mortgage outstanding.

To enter the agreement, John would need to commit two-thirds of his savings to an asset without legal ownership. This not only puts his savings at risk but also exposes him to significant additional expenses, further increasing his financial vulnerability.

If John loses his job and is unable to maintain the agreement or secure a mortgage at the end of the rental term, his total loss from the rent-to-own arrangement could far exceed the option deposit, rent credits, and additional property expenses. The lost opportunity cost of $25,000+ invested in a TFSA, combined with all the additional expenses, could exceed $150,000 over 25 years. The risk-to-reward ratio for this rent-to-own agreement is unfavorable for John.

In summary, while rent-to-own arrangements might seem like an ideal route to homeownership, they often prove to be more expensive and problematic than anticipated. These contracts typically require paying above market value, offer no ownership rights or protections, and may leave you unable to qualify for a mortgage at the end of the term, leading to substantial financial losses.

Individuals like John would be better off focusing on building their financial foundations by accumulating and investing savings in tax-advantaged accounts such as FHSAs, TFSAs, and RRSPs. They should only consider purchasing a property through traditional methods when it makes financial sense. This approach is significantly less risky, provides more flexibility, and has a much higher probability of success.

Sinan Terzioglu, CFA, CIM, is a financial advisor with Turner Investments, Private Client Group, Raymond James Ltd.  He served as vice-president of RBC Capital markets in New York City and VP with Credit Suisse in Toronto.

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Source: https://www.greaterfool.ca/2025/03/30/the-perilous-path-of-rent-to-own/