DSCR Loan: A Guide for Property Borrowers
7 MIN READ
Published October 23, 2023 | Updated November 09, 2023
A debt-service coverage ratio (DSCR) measures available cash flow to pay debt obligations. This financial ratio shows lenders whether you’ve got enough income to service your debts.
So, what is a DSCR loan? A DSCR loan is a non-conventional loan where lenders determine your ability to repay the loan using the DSCR ratio instead of verifying income. It offers real estate investors an alternative financing option when they cannot qualify for a traditional mortgage.
What Is a DSCR Loan?
The debt-service coverage ratio (DSCR) is a widely used financial indicator to measure a company’s financial health. Debt service refers to the amount of cash needed to repay the loan during any given period. It measures your business debt against your operating income.
A DSCR loan is a home loan that doesn’t require conventional income verification. Instead of W-2s or pay stubs, lenders consider cash flow from investment properties to assess the borrower’s ability to repay the loan. This is a good alternative for real estate investors who may claim many business deductions and write-offs and may not be able to qualify based on tax returns or pay stubs showing the required minimum income levels.
Repayment Terms and Interest Rates
You can typically use DSCR loans for several property types, such as commercial property, multi-family property, short-term or vacation rentals, or single-family residential properties. Compared to conventional loans, DSCR loans have higher interest rates. The current average interest rate is 8.09%.
DSCR loans require a down payment of 20% to 25%, depending on the Loan-To-Value (LTV) ratio. If you’re investing for the first time or your DSCR is lower, the lender may ask for a larger down payment.
How To Qualify for a DSCR Loan
Although it’s easier to qualify for a DSCR loan compared to a conventional mortgage for investors, lenders will still review several qualifying criteria to determine your eligibility.
Lenders offering DSCR loans don’t consider your personal income, but in most cases, they’ll still review your creditworthiness. Most lenders require a FICO score of 620 or more. Your credit score reflects your repayment history and allows lenders to determine their risk level. If you’ve got a higher credit score, you may be able to qualify for a lower interest rate and better loan terms.
DSCR loans usually require a down payment of 20% to 25%. For example, if the LTV is 75%, the down payment would be at least 25%. If your DSCR ratio is lower than 1, the property may be unable to cover the debt fully. In this case, the lender may ask for a higher down payment.
Income and Cash Flow
Instead of verifying your income through tax returns or pay stubs for the investment property loan, lenders will review your cash flow while assessing your eligibility for the DSCR loan program. In most cases, lenders will require a minimum DSCR ratio of 1. A higher ratio indicates that your property's cash flow is higher than the mortgage payments, making your application more secure.
Lenders may also ask for 6-12 months of cash reserves if you're a new investor. They may also ask for sufficient cash reserves if your credit score or DSCR ratio is low. This is also a requirement when you’re buying short-term rentals because they’re considered riskier investments.
Pros and Cons of DSCR Loans
Like any other type of loan, such as mezzanine and no doc mortgage loans, DSCR loans have pros and cons. As a borrower, you need to weigh them carefully.
- DSCR loans are easier to access for many borrowers because there’s no income verification.
- The approval process is faster and more streamlined.
- DSCR loans come with unlimited cash-out, so you can take out money when needed.
- You can use the loan funds to buy all types of rentals.
- Unlike traditional loans, you can purchase multiple properties at once with DSCR loans.
- You’ll need to put down at least 20% for the loan.
- The interest rates are higher than conventional mortgages.
- Loan funds can’t be used to purchase a primary residence.
- If there are many vacancies, it may be difficult to repay the loan.
- There may be a prepayment penalty if you pay off the loan sooner.
Who Is a DSCR Loan For?
DSCR loans are usually a good fit for:
- Freelance or self-employed people wanting to invest in real estate.
- Investors who want to build a portfolio of rental properties.
- People who want to invest in niche areas like short-term rentals or BRRR (buy, rehab, rent, refinance, repeat) properties.
Conventional mortgages must abide by strict rules established by Fannie Mae and Freddie Mac. DSCR loans are good for alternative borrowers who want to pursue newer, unconventional investment strategies. These loans are also a good fit for anyone who wants to invest in straightforward properties for long-term leases and single-family rentals.
“It’s important to note, conventional loans are most often underwritten and approved using your Debt-to-Income (or DTI) ratio, which looks at personal income vs personal debt,” explains Brad Reichert, founder and managing director of Reichert Asset Management LLC.
“When a self-employed investor is using a conventional loan, the payment for the new loan will be included in the DTI ratio calculation as debt. If the expected income from the new rental property (or your other properties) is not sufficient to push the new DTI ratio back down to an acceptable level, you likely won’t get approved for the conventional loan,” Reichert says. “Hence, the rapidly-growing popularity of DSCR loans in recent years, as real estate investors seek out profits from rapidly rising property values,” he adds.
How To Calculate DSCR
The debt service coverage ratio is calculated by dividing the net operating income by the property’s debt obligations.
For example, if a property has a rental income of $60,000 and an annual debt of $40,000, the DSCR ratio is 1.5 ($60,000 divided by $40,000). This means the property has a positive cash flow and generates enough income to repay the loan.
Let’s look at another example to understand how a DSCR loan works.
Suppose you want to purchase a property worth $400,000. The property generates an annual income of $200,000 and has an annual expense of $60,000. The yearly debt service for the property is $80,000.
To calculate the DSCR ratio, you’ll first need to calculate the annual net operating income of $140,000 ($200,000 - $60,000). Divide this figure by the yearly debt service, and you’ll get a DSCR of 1.75 ($140,000 divided by $80,000). This is a good DSCR and indicates that you’ll be able to repay the loan comfortably.
If the LTV is 80% and the down payment is $80,000, you’ll get a loan amount of $320,000. The interest rate for the loan is 8% annually, so your monthly loan payments will be $2,348.
You can also use a DSCR loan calculator to estimate your DSCR ratio, monthly payments, and down payment.
The Bottom Line on DSCR Loans
DSCR is a financial metric that compares a borrower’s debt payments to their operating income. Lenders offering DSCR loans use this ratio to assess if you’ve got enough income to meet loan obligations. Real estate investors can finance their property without providing tax returns or personal income proof. Instead, DSCR loans offer a faster closing time, relaxed underwriting, and an alternative financing option.