What are DSCR loans?
A DSCR loan or debt service coverage ratio loan allows real estate investors to buy properties based on the rental income the properties generate. Borrowers do not need to prove they have adequate personal income to meet their debt obligations. Instead, the lender relies on the property’s cash flow for repayments.
DSCR loans differ from conventional mortgages in the following ways:
- DSCR loans are approved based on the cash flow of a rental property, not on the borrower’s personal income.
- A DSCR loan, which is a type of non-QM loan*, does not require a prospective borrower to furnish tax returns or other financial documents. These are generally required in conventional mortgages.
- DSCR loans typically require a higher down payment and generally have higher interest rates.
*Non-QM loan: A non-QM loan or non-qualified mortgage loan is designed to meet the requirements of non-traditional borrowers. Some real estate investors do not qualify for a conventional mortgage because they have inadequate personal income. These investors could purchase a property using funds from a non-QM loan.
How do DSCR loans work?
DSCR loans are based on a property’s rental income. When appraising a DSCR loan, a lender will look closely at how the property’s income compares with the corresponding debt obligation. Specifically, the lender will see if the rental property’s annual net operating income exceeds the total loan payments due in a year.
It is useful to remember that a mortgage lender appraises a DSCR loan application by assessing whether the property’s cash flow is adequate to meet the total mortgage payment that is due annually. A higher rental income implies the property’s cash flow is also higher. Lenders view this positively, increasing the loan applicant’s chances of getting approval. The borrower’s personal income usually does not come into the picture when a loan application is being processed.
Debt service coverage ratio formula
A property’s debt service coverage ratio can be calculated by dividing its annual net operating income by its annual debt service payments.
To calculate the debt service coverage ratio accurately, ensure that the annual net operating income and debt obligations are computed correctly. Here is how the two figures are worked out:
- Annual net operating income: The annual NOI is determined by subtracting property management fees, expenses for repairs and maintenance, and other expenses from the property’s annual rent.
- Annual debt service obligations: Annual debt service includes principal and interest payments and property taxes, insurance, and HOA (homeowners association) fees.
DSCR calculation example
Here is an example explaining how the debt service coverage ratio is calculated.
Consider an investment property that provides its owner with a monthly income of $10,000. The annual expenses in connection with the property are $15,000. This figure includes property management fees, costs for repairs and maintenance, and other expenses.
The annual net operating income of the property can be calculated in the following manner:
Monthly rent of $10,000 X 12 = Annual rent of $120,000
Annual expenses as stated above = $15,000
Annual NOI = $120,000 – $15,000 = $105,000
The property’s annual debt service obligation is $100,000. This figure includes principal and interest payments, property taxes, insurance, and HOA fees.
The annual NOI and the annual debt service obligation can be used to calculate the debt service coverage ratio:
Debt service coverage ratio = Annual net operating income / Annual debt service payments
DSCR = $105,000 / $100,000
DSCR = 1.05
A DSCR of 1.05 indicates that the rental property generates an annual NOI of just a little more than its annual debt obligations. Remember that if the property has a greater positive cash flow and its yearly debt obligations remain the same, the DSCR will increase. Getting a DSCR loan approved will be easier for the borrower in such a situation.
What is a good DSCR ratio?
Lenders prefer a high debt service coverage ratio. As a general rule, the higher, the better. An investment property with a debt service coverage ratio of one indicates that the property makes just enough money to meet its debt obligations. Even the slightest hiccup, such as an extended vacancy at the rental property or an unexpected repair expense, can lead to negative cash flow.
Consequently, the DSCR ratio would fall to less than one, and the lender can face a situation where the borrower fails to meet the repayment obligation. Most lenders prefer a DSCR ratio of 1.25. However, a ratio that is closer to 1.5 is preferable.Real estate investors need to keep another thing in mind. A higher debt service coverage ratio can get them a lower rate of interest on a DSCR loan. Lenders may offer this benefit because a higher ratio tells them that the property has a healthy cash flow that is likely to remain positive even if there are some unexpected vacancies or expenses.
Pros and cons of a DSCR loan
DSCR loans can be a boon for borrowers who do not qualify for conventional mortgages. Lenders are willing to advance funds based primarily on the property’s cash flow. However, DSCR loans have drawbacks, too. The following table summarizes the pros and cons of DSCR loans:
| Pros | Cons |
| A good option for investors who do not qualify for conventional mortgages. | Lenders generally require a high down payment. 20% is the standard. |
| DSCR lenders are usually more flexible than conventional mortgage providers. | Interest rates are high, as well. |
| The approval process is typically quicker than the process for conventional mortgages. | Mortgages are only available for rental properties that generate an adequate income. |
| Less documentation. | If a property has a DSCR of less than one, which implies a negative cash flow, the loan is unlikely to be approved. |
| Investors can obtain finance for multiple rental properties. | Ordinarily, a DSCR loan will have a higher origination fee as well as greater prepayment penalties than a conventional mortgage. |
| A larger loan size is possible. | The borrower needs to meet the lender’s minimum credit score requirement. |
DSCR loan requirements
Investors applying for DSCR loans should know that to qualify, they need to meet certain conditions:
- Minimum credit score: Each lender sets a minimum credit score requirement that it expects borrowers to meet. Although the minimum score specified can differ, it is usually between 620 and 680. A higher score can mean the investor can make a lower down payment.
- Minimum loan amount: Again, this differs from lender to lender. However, most lenders set a minimum loan amount of $100,000 or $150,000.
- Appraisal: A lender wants to know the property’s market value and rental income. An appraisal report would need to be furnished to meet this condition.
- Property type: Typically, lenders consider both residential and commercial properties acceptable. Consequently, borrowers can get approval for a DSCR loan for single family residences, multifamily units, and different types of commercial properties. A DSCR loan is not available for an owner-occupied property.
- Positive cash flow: The property must have a positive cash flow. This is a fundamental requirement for a DSCR loan. If the real estate asset does not generate income, it will not qualify for a DSCR loan.
How to secure a DSCR loan
Here is a step-by-step description of how to secure a DSCR loan:
1. Find a DSCR loan lender
Every lender does not provide DSCR loans. So, the first step you need to take is to check whether the lender you have identified offers these loans. Verifying the lender’s experience level in DSCR lending would also be a good idea.
2. Complete the loan application
You will be required to furnish several details about the property that you plan to buy. The primary information lenders seek includes documentation proving the property’s income. Borrowers will also be required to provide particulars about the property’s expenses.
3. Calculate your DSCR ratio
It is crucial that the DSCR ratio meets the lender’s minimum requirement. A higher ratio signifies that the property’s cash flow can comfortably meet the loan repayment obligations. Bear in mind that a ratio of less than one implies that the property has a negative cash flow, a factor that may result in your loan application being rejected.
4. Get approved and lock in your interest rate
Most DSCR loans are fixed-rate loans, with the interest rate remaining the same for the duration of the loan. However, some lenders also offer borrowers different options. One variant is a DSCR loan that requires interest only payments for the initial period of the 30-year loan. The interest only period can vary from five to seven years or even 10 years in some instances.
Another variation is the adjustable-rate DSCR loan. In this variant, the interest rate can change over time. Borrowers should read the loan agreement carefully and familiarize themselves with the impact a change in interest rates can have on their finances.
5. Receive the loan and make repayments
As with any other loan, it is crucial to meet your repayment commitments. It will be easier to do this if your property has a high occupancy rate and your rental income is sufficient to meet your repayments. A high DSCR ratio will ensure you have a cash cushion to help you tide over periods where you experience a reduction in rental income.
When a DSCR loan might not be the best fit
A DSCR loan can be an excellent option for borrowers who are unable to qualify for conventional mortgages. It is also a good way to raise funds to purchase an investment property if the borrower’s personal finances do not meet the lender’s approval criteria.
However, DSCR loans are not a good fit in certain situations. For example, a DSCR lender would not approve a loan application that seeks to finance the applicant’s primary residence. Conventional mortgages are designed to meet the needs of borrowers who want to buy a home to live in.
What if an individual is not eligible for a conventional mortgage and wants to buy a primary residence? Bank statement loans offer a way out. Lenders use the financial activity recorded in borrowers’ bank statements to determine their creditworthiness.
DSCR loans are also not the correct type of loan when an investor buys a property to renovate and subsequently sell for a profit. Finally, most DSCR lenders have a minimum threshold below which they will not lend. This threshold can be between $100,000 and $150,000.
Risks involved in DSCR loans
Real estate investors using DSCR loans to acquire property can be caught wrong-footed in the following situations:
- When there is a drop in rental income: Repayments are dependent upon the cash flow from the rents received every month. If, for any reason, the rent remains unpaid or a tenant unexpectedly terminates a lease, there may not be enough money to meet the interest and principal payments.
- A reduction in cash flow due to operational issues: If the property is not well-managed, landlords may see a drop in net operating income. Unexpected legal matters, an increase in repair costs, or a dispute with a tenant can drain cash resources.
- A downturn in the property market: In times of economic decline, property prices and rentals can decline. Tenants would be in a stronger position to negotiate with landlords. The rent a property owner receives can drop, leading to difficulties in loan repayments.
The bottom line
A DSCR loan allows a real estate investor to raise funds for a new acquisition based on the cash flow from the property’s rental income. The lender does not examine the personal finances of the borrower. This can be a great advantage for an investor who does not meet the credit requirements for a conventional mortgage loan. However, DSCR loans have drawbacks, too. The down payment is usually in the 20% range, and interest rates are higher than those charged for a conventional loan.
