Lenders offer debt service coverage ratio (DSCR) loans to investors or business owners to finance new holdings based on the cash-flow of their current investment and not their personal finances. Real estate investors commonly use it to leverage the income from current rental properties.
For example, If you are a real estate investor, the lender looks at your ability to generate cash flow from your current investment(s) in relation to your monthly debt payments and expenses to calculate the DSCR and determine the risk of the loan and likelihood of approval.
While the DSCR measurement is common in many aspects of finance, business, and government, when referring to a DSCR loan, it usually refers to loans for real estate investments, both commercial and residential.
How to Calculate a DSCR
To calculate the DSCR, lenders use two measurements, net operating income (NOI) and total debt service (TDS). The NOI is a measurement of the revenue generated by a business or investment after you deduct operating expenses. You calculate the TDS by taking all monthly debt payments related to an investment and dividing the result by gross earnings from the property. To figure the DSCR, you divide net operating income (NOI) by total debt service (TDS).
For example, if you, as an investor, have an annual NOI of $200,000 on a rental property with an annual TDS of $110,000, the DSCR is 1.182
NOI / TDS = DSCR
$200,000 / $110,000 = 1.182 DSCR
Lenders use the DSCR to determine your ability to meet your debt obligations and to set the terms of the loan. A higher DSCR shows to the lender you have a high ability to cover your debt service payments and lenders consider you a lower risk borrower. Lenders consider a lower DSCR a sign the borrower might have difficulty meeting their debt obligations and a higher risk borrower.
A DSCR of higher than 1.2 shows a lender your current investment generates enough cash to cover the debts. Lenders usually look at anything lower than 1.2 as a negative and it can affect the loan terms, or the ability to be approved at all. If you have a DSCR of 1, it means you will break even, and you are making just enough to cover the current debts. A lender would likely see this as too high a risk to offer a loan.
So in the example above, you, with a DSCR of almost 1.2, would be more likely to be approved for a DSCR loan than someone with a DSCR of.9 who currently cannot service their debts with the money generated from their investments. However, DSCR loan requirements change with the market conditions and it is important to check with specific lenders if you are considering a DSCR loan.
Pros and Cons
If you have real estate investments that generate cash flow, a DSCR loan might be a good option to consider if you want to grow your investment portfolio. There are many positives to this type of loan, like flexibility and removal of your personal finances from the equation. But, like any financial product, there can also be downsides, like high interest rates and higher down payment requirements.
DSCR Loans Pros
Below are the positive features of using a DSCR loan.
Allows You to Scale Your Business
A DSR loan can help you grow your investment portfolio by allowing you to leverage your existing assets to gain additional properties or investments. By using a DSR loan, you can increase your purchasing power and acquire more investments than you would be able to with just your own funds.
For example, if you are a real estate investor who has a high DSCR, meaning you have positive cash flow each month, a lender could approve you for a DSRC to buy an additional property. You can use the funds from your current investments to purchase another rental property, which would generate additional income to further diversify your portfolio. You can fund the purchase of multiple properties, because there is no limit to the number of properties you can purchase with a DSCR loan, as long as you qualify.
Separates Personal and Business Finances
Lenders usually secure DSCR loans using the income from your investments and do not require a personal guarantee. This means that your personal assets aren’t at risk in the event of a default. This can help to protect personal finances from the risks associated with business and investment activities.
Easier Approval and Fast Closing
Applying for a conventional loan can be time consuming and take a long time for approval. A DSCR loan is based solely on the fact that you are bringing in enough income in relation to your expenses to make your loan payments. With no need for endless amounts of tax and earning paperwork, the approval and underwriting process can take much less time than other types of loans. Less documentation can also mean a faster closing. For example, in California, a DSCR loan can close in as little as 21 days, while a conventional mortgage can take up to five weeks.
Cash Out Options
Some DSCR loans offer a cash-out option if you have equity in your current investments. A cash-out option can give you access to funds that you can use for a variety of reasons like making improvements to a rental property, paying off debt, or supporting other business activities by increasing cash flow.
Versatile Options And Flexibility
With conventional loans, there are different requirements for different types of properties. DSCR loans are available for a variety of loans like purchases, refinancing, new construction, multi-unit buildings,and even renovating an existing property. You can also finance multiple properties at once. With some conventional loans, there is a limit to the number of properties you can have financed at one time.
DSCR Loans Cons
Below are the negative aspects of using a DSCR loan.
High Down Payment
DSCR loans can be more expensive than other loans because they usually require a minimum of 20% of the loan value as a down payment. However, if you are a real estate investor, you can sometimes use equity or take the down payment from the properties rental income.
Limited as your Business Grows
Lenders cap most DSCR loans to about $5 million. So, if your portfolio will grow to where you have investments past that amount, you will probably outgrow this type of loan.
Higher Interest Rates
DSCR loans generally have interest rates about 1.25% to 1.5% higher than conventional loans. For example, in the beginning of March 2023 the DSCR rates were up to 2.25% higher than conventional loan rates.
DSCR loans sometimes have a prepayment penalty if you want to pay your loan off early, which takes away from your bottom line. It is important to investigate this with lenders before applying for a loan.
Your Credit Matters
While you don’t need verification of your personal income, lenders usually have a minimum credit score if you apply for a DSCR loan. The credit score threshold, however, isn’t much different from other conventional loans you would use for investment properties. But, if you were hoping to get a loan without your finances being considered at all, this could be a drawback.
The primary purpose of the DSCR when applying for a loan is the lender’s ability to evaluate whether you can meet your current debt obligations and a new loan. If you want to leverage cash from your investments, but don’t qualify for a conventional loan using your personal income, a DSCR loan might be a good option to research.