Key takeaways
- The DSCR ratio measures the amount of cash flow that a property can generate in comparison to its debt.
- While DSCR loans are designed for real estate firms and organizations, they are also an option for individual borrowers and real estate investors.
What is Debt Service Coverage Ratio (DSCR)?
The debt service coverage ratio (DSCR) is a ratio of a property’s potential annual growth income along with its annual debt, including principal, interest, and any additional expenses. This ratio allows lenders to determine how much of a loan a specific investment property can support and helps them determine the borrower’s ability to pay the mortgage.
How to calculate your DSCR
In order to calculate a property’s DSCR, the annual gross rental income of the property (net operating income) must be divided by the specific mortgage debt obligations of the property. This does not take into account the debts for property management, utilities, or other operating expenses. For example, if an investor is looking at a property that generated a gross rental income of $100,000 and an annual debt of $80,000, the DSCR would be 1.25.
What is a good DSCR?
In general, most lenders will require at least a 1 -1.25 DSCR in order to qualify for a DSCR mortgage loan. The higher the score, the better the interest rates a borrower will receive. Scores lower than 1.0 often mean that the property has the potential for negative cash flow and increases the risk to the lender.
Factors that affect the DSCR ratio
The DSCR ratio is only affected by two things: the net operating income and the debt obligations. If the property has no rental income history, the lender will require a rental comparison analysis that will help determine the property’s potential rental income.
Why does DSCR matter?
The DSCR evaluates a borrower’s ability to pay their debts on an investment property. It helps the lender determine the risk they will assume when providing a DSCR loan to the borrower.
Overview of DSCR loan
Debt service coverage ratio loans are designed for real estate investors and organizations looking to qualify for a mortgage based only on the cash flow generated by the specific property instead of traditional factors such as proof of income, employment history, and tax records.
Benefits of DSCR loans
Choosing a DSCR loan provides many different benefits to real estate investors, including:
- No need to provide personal financial information as the lean is dependent on the DSCR ratio.
- Allows for multiple loans at one time.
- Lack of documentation requirements allows for quicker application and closing times.
- Offers the options of interest-only payments
- Cash-out options allow investors to take cash out on one or multiple properties at a time, allowing an investor to invest in more properties.
Disadvantages DSCR Loan
DSCR loans are not made for every real estate investor and can have some downsides. Here we look at some common disadvantages associated with a DSCR loan.
- Higher down payments and terms: The necessary down payment for a DSCR loan can range between 20% – 25%, and interest rates are often 1-2% higher than traditional loans, even more, if there are no current leases on the property. There will also be lender and service fees due at closing that can range between 0.5%-1% of the loan amount.
- Dependent on the market: Most lenders require a DSCR ratio of at least 1. In areas with low rent and high property value, a qualifying DSCR ratio may be difficult to obtain.
- Unoccupied properties require a lender to analyze the potential rental income, often making it more difficult to qualify.
- Loan limits are often capped, meaning a DSCR loan is not often available for larger real estate complexes or properties.
Common uses of DSCR loans
DSCR loans are designed for the purchase of investment properties. They are available to commercial real estate investing companies and personal real estate investors. If a borrower is looking for a primary residence, a DSCR loan is not an option.
How to qualify for a DSCR loan
In order to qualify for a DSCR loan, a borrower will need to ensure that the property can generate enough income to meet the lender’s minimum DSCR ratio. In addition, borrowers will need a credit score of at least 640 for most lenders and the ability to put at least 20%-25% down on the property to qualify.
Understanding your DSCR loan
If you are looking to grow your real estate investments without leveraging your personal finances, a DSCR loan allows for that flexibility, often helping new real estate investors build a rental income portfolio based on their rental properties. Instead of using your personal income, you can leverage your property’s earning potential.
