What is a DSCR Loan? How it Works & How to Qualify
Apr 12, 2023
As a real estate investor, one of the most important and often annoying aspects of investing is financing.
Whether you're considering residential, single family homes or commercial properties, you'll need to find a way to finance your project. While there are various paths to take - from hard money loans, to conventional, syndicates and vacation financing. But one option that you might consider is a DSCR loan. In this blog post, we'll explore what a DSCR loan is, how it works, and its benefits for real estate investors - whether you're a seasoned pro or a newbie investor.
What is a DSCR Loan?
A DSCR loan, or Debt Service Coverage Ratio loan, is a type of loan that lenders use to evaluate a borrower's ability to repay a loan. The DSCR ratio is calculated by dividing the net operating income (NOI) of the property by the total debt service (TDS) of the loan.
The net operating income (NOI) is the income generated by the property after deducting the operating expenses. The total debt service (TDS) includes monthly debt payments, such as principal and interest payments.
DSCR loans can be used for a rental house, duplex, commercial project or multifamily property. While some commercial banks may not offer a DSCR mortgage, most brokers will have access to the style of loans.
Debt Service Coverage Ratio Calculation
The DSCR ratio is expressed as a number. The ratio is calculated as monthly rental income divided by the mortgage payment. The typical range is 1.0 - 1.5 or 2.o. The goal of the bank or underwriter (and frankly, you as the investor) is to ensure the property does not have a negative cash flow. More on that later, but in short, you'll want to have sufficient "coverage" for your debt service payments.
How Do DSCR Loans Work for Investment Properties or Rental Homes?
A DSCR loan is specifically designed for real estate investors who are purchasing investment properties or rental homes. Lenders evaluate the property's financial statements and rental projections to determine the DSCR ratio. If the DSCR ratio is above a certain threshold, the lender will approve the loan. Jackpot! No worrying about W2's and debt-to-income.
Unlike traditional loans, where the borrower's credit score, personal income and tax returns are taken into account, DSCR loans focus on the property's ability to generate positive cash flow. This means that real estate investors with a strong cash flow property can qualify for a loan even if they have a lower credit score or income.
The loan payments are based on the DSCR ratio, and the lender may require the borrower to maintain a certain DSCR ratio throughout the life of the loan. If the property's DSCR ratio falls below the required threshold, the lender may take action, such as increasing the interest rate, requiring additional collateral, or even calling in the loan.
How to Calculate DSCR
Calculating DSCR (Debt Service Coverage Ratio) is a crucial step in evaluating the feasibility of a loan for real estate investors looking to purchase investment properties or rental homes. To calculate DSCR, divide the net operating income (NOI) of the property by the total debt service (TDS) of the loan.
The net operating income is the income generated by the property after deducting the operating expenses such as taxes, insurance, and maintenance costs. Total debt service (TDS) is the total amount of debt payments, including principal and interest, that the borrower has to make during a given period.
A DSCR ratio of 1 means that the property generates just enough cash flow to cover its debt obligations, while a DSCR ratio of 2 means that the property generates twice the cash flow needed to cover its debt obligations. The higher the DSCR ratio, the better the property's ability to generate income to cover the loan payments. A negative cash flow would result in a DSCR of under 1.0 because it does not generate enough in monthly rent to provide sufficient coverage.
Advantages of a DSCR Loan for Real Estate Investors
Here are some of the key benefits:
- Offers a higher loan amount than traditional loans. This is because the lender is evaluating the property's ability to generate income rather than the borrower's personal income. This means you can get a loan based on the strength of hot market and the property.
- Personal income is not critical to underwriting. DSCR loans do not generally consider your personal recurring income (e.g. W2 salary).
- DSCR loans may offer a longer repayment term, allowing investors to spread out their loan payments over a longer period.
- Allows investors to leverage their investment property or rental home to finance their investment. The cash flow generated by the property is used to cover the debt service, allowing investors to use their cash on hand for other investments.
Net Operating Income
As a real estate investor, you'll need to understand the importance of DSCR and Net Operating Income (NOI) in evaluating the feasibility of a loan. DSCR (Debt Service Coverage Ratio) measures the property's ability to generate cash flow to cover the debt payments, while NOI represents the property's revenue minus operating expenses.
DSCR loans require a DSCR ratio of at least 1.2, meaning that the property must generate 20% more cash flow than the annual debt payments. Although DSCR loans may seem expensive, they offer higher loan amounts and longer repayment terms, making them attractive financing options for rental property investors.
Qualifying for a DSCR Loan
Rental properties with a positive cash flow and a high Gross Rental Income (GRI) are more likely to qualify for DSCR loans. The rental income generated by the property must cover the monthly mortgage payments and pay current debt obligations. Moreover, investors must have a down payment of at least 20% to qualify for DSCR loans.
DSCR loans are suitable for commercial or multifamily properties and can help investors expand their real estate portfolio. To qualify for DSCR loans, lenders will evaluate the property's net operating income, debt service coverage ratio, and interest coverage ratio.
When it comes to commercial real estate investing, DSCR (Debt Service Coverage Ratio) loan programs are a popular financing option. DSCR loans typically require an annual net operating income (NOI) that exceeds the mortgage payment by at least 25%. These loans are typically available for multifamily properties and commercial real estate investments.
DSCR loans offer reasonable interest rates and terms as well as interest-only loans, and typically require a maximum loan-to-value (LTV) ratio of 80%. Lenders typically require a DSCR of 1.25 or higher and most lenders will evaluate the monthly rental income generated by the property.
In conclusion, a DSCR loan is an excellent option for new or seasoned real estate investors looking to purchase investment properties or rental homes. It evaluates the property's ability to generate income, allowing investors with strong cash flow properties to qualify for loans even if they have a lower credit score or income.
Most DSCR mortgages will still require a 20% down payment, which is consistent with conventional financing. However, DSCR products offer a higher loan amount and often a longer repayment term, making it an attractive financing option. As with any loan, it's important to evaluate your financial situation and consider all your options before making a decision.