If you’re a landlord or considering purchasing a rental income property, consider a debt service coverage ratio (DSCR) loan to fund your next purchase. DSCR loans are specifically designed to finance rental properties and can be easier to qualify for than a conventional mortgage as they leverage the property’s cash flow instead of a buyer’s income, tax returns, and W2.
Today’s article will cover the finer points of DSCR loans, DSCR loan requirements, how to qualify, and their flexibility for real estate investors.
What is a DSCR Loan?
DSCR loans are specific to residential income-producing properties and are fast becoming the preferred option for income property buyers. DSCR loans are mortgages secured by the property’s rental income and do not require the buyer to provide the same documentation needed with a mortgage for owner-occupied properties. This feature is especially helpful for self-employed investors who may not have a conventional income stream or have been challenged to obtain financing through traditional banks.
Some things to note about DSRC loans:
- Only properties with one to four units are eligible for DSRC lending, as additional units in the building would classify it as “multi-family.”
- DSCR eligibility assumes the property is turnkey, meaning it requires no renovation or upgrades and is move-in ready or has an established, reliable tenant.
- Lastly, the property must be a business asset or income investment, meaning the owner cannot reside at the address.
How DSCR Loans Are Calculated
DSCR loans are based on a calculation that assesses the potential for the property to cover its expenses. The calculation divides the property’s net operating income (NOI) by its total debt service (TDS) to obtain a number less than, greater than, or equal to 1.0.
Net operating income is calculated by subtracting the total operating expenses from the gross rental income.
Total debt service is the total of all debt-related expenses the property must pay.
The DSCR ratio is what tells the borrower and lender how much income to debt the property is generating to cover (or not cover) its own expenses.
- DSCR > 1 means the property is generating enough income to cover its debt
- DSCR = 1 means the property is just breaking even with enough income to cover its debt
- DSCR < 1 means the property isn’t generating enough income to cover its debt, posing a greater risk for lenders.
Let’s look at an example:
What this means is this property is generating $150,000 in income with total expenses equalling $100,000. This results in a DSCR of 1.5, so the property yields 50% more income than what’s needed to cover its debt, making it a more acceptable threshold for a lender to consider financing.
DSCR Loan Requirements
The criteria for a DSCR loan are vastly different from that of a traditional mortgage. Whereas a bank will want proof of income, a W2, and tax returns and consider your personal credit, a DSCR loan is more concerned with the property’s earning potential.
The buyer must provide the property’s current income and expense reports, a verifiable property appraisal, and a credit check. However, DSCR loans have a much less stringent benchmark for personal credit than would be the case with a conventional mortgage.
Traditional lenders lean more on the buyer’s credit score and income than the property’s income. DSCR loans turn that equation upside down; though the buyer’s personal credit has some weight, it is a minor factor compared to the property’s earning potential.
DSCR Loan Pros and Cons
While DSCR loans are often easier and faster to obtain a mortgage from a bank, there are some caveats to consider.
On the plus side, DSCR loans are an excellent option for investors who do not have a traditional source of income. Since they are strictly used for investment, they can help people quickly build a real estate portfolio without having to prove personal income.
Many investors find DSCR loans helpful when working with other investors as they allow for a shared ownership, making it possible to borrow in partnership with others through an LLC.
Depending on the buyer’s financial situation, there may be drawbacks to DSCR loans. For one, the required downpayment is often higher than would be the case for a traditional mortgage. Higher interest rates, closing costs, and additional fees should also be considered. DSCR loans are considered to be higher risk as they do not require personal income verification, hence, they often come with higher fees. In some cases, there may also be a prepayment penalty, meaning you’re locked into your payments for the loan term.
Additionally, buyers may not have the same protection as a conventional mortgage because government agencies do not back DSCR loans.
The above point underscores the importance of ensuring the property’s income potential holds up, as cash flow problems may lead to financial distress or foreclosure. DSCR loans are not recommended for properties lacking stable income or in areas with challenging or volatile real estate markets.
Is a DSCR Loan Right for You?
DSCR loans offer incredible flexibility and are fast becoming the preferred loan vehicle for residential real estate investors today. Working with a lender well-versed in DSRC financing will give you the expertise and options you need to achieve your investment goals.
Ultimately, DSCR loans may be a better option for self-employed investors, investment partnerships, or in scenarios where the property’s income potential comfortably exceeds its expenses.
However, a conventional mortgage may be a more suitable and affordable choice for first-time buyers or anyone who plans to live at the property.
To learn more about the different types of loans available for your next real estate investment, we’re here to help. Contact LendingOne today.