Debt-Service Coverage Ratio (DSCR) Loans
What is a DSCR Loan?
Dive deeper into what DSCR Loans with Visio Lending CEO Jeff Ball featured on Rob Chrisman Podcast:
What is the Debt-Service Coverage Ratio (DSCR)?
The DSCR is a tool to help lenders understand a borrower’s ability to pay back a loan based on the monthly rental income of the property.
DSCR is a simplified way to measure cash flow and is calculated by dividing the monthly rent by the monthly principal, monthly interest payments, taxes, insurance, and association dues (collectively known as PITIA).
For a commercial or multi-family property, DSCR is calculated by dividing the annual Net Operating Income (NOI) by the annual debt service (same thing as the annual PITIA).
For example, if a property generates a Net Operating Income of $100,000 annually and its annual debt service is $81,783, the equation would like this:
The annual debt service in this example is less than the Net Operating Income, which makes the monthly cash flow positive.
DSCR Loan Property Types
DSCR loans typically can be used for the following property types:
- Single-family (1-4 unit) residential rentals
- Vacation or short-term rentals
- Commercial or multifamily property
DSCR loans typically cannot be used for the following property types:
- Single-family (1-4 unit) residential rentals
- Vacation or short-term rentals
- Commercial or multifamily property
Why Investors Should Consider DSCR Loans
Minimum Down Payment
Also referred to as investment property loans, Non-QM loans, and rental loans, among other synonyms, DSCR loans have become quite trendy recently. So what is all the buzz about? While it is possible for investors to obtain a conventional loan or funds through a small bank, this financing is tedious to qualify for and has substantial liquid reserve requirements. DSCR Loans, on the other hand, are specifically designed for the professional real estate investor to use cash flow generated by the property as a qualification. Let's take a closer look.
DSCR Loans are Underwritten Based on Gross Rental Income Instead of Personal Financial History
Experienced real estate investors with multiple mortgaged investment properties and self-employed investors without W2's often have difficulty meeting conventional loan criteria. The credit, reserve, and income requirements of conventional loans are strenuous. Further, they are underwritten using Debt-to-Income ratio or DTI, which looks at your personal assets compared to your personal debt. If you are trying to finance the purchase of a rental property with a conventional loan, the payment for the new loan will be included in the debt portion of your debt-to-income calculation. Whether you can offset that new monthly payment with a portion of the expected rent will depend on how well you can document the actual or expected rents from the property.
Investors that have a lot of personal income from non-rental sources, may be able to cover the “cash flow gap” on their DTI calculation up to some point. Investors who are self-employed or who have multiple mortgaged investment properties may not have income from other sources to cover this gap. Using debt service coverage ratio eliminates DTI from the underwriting and instead focuses on the rental income from the subject property relative to its monthly payments.
DSCR Loans Allow Investors to Borrow in an LLC or Entity
Many experienced investors prefer to borrow through an LLC or corporation to protect their identity and other investments. This adds an extra layer of protection to the investor's personal assets for any unfortunate incidents on the property. Conventional loans can only be obtained in an individual(s) name.
Most DSCR Lenders have more flexible common sense limitations on the maximum number of properties financed
Even if an investor has enough personal income to support multiple mortgaged rentals, with traditional loans you are maxed out at ten loans. Most DSCR lenders do not have set limits but instead use common sense when evaluating an investor's maximum credit exposure.
DSCR loans require less documentation
When applying for a conventional mortgage, you have to gather all of your pay stubs, bank and asset statements, and tax documentation, including tax returns. The underwriters are going to dive deep into your personal financial documents and history, which is time consuming and tedious. Any missing documentation or schedules in your tax returns can lead to lengthy delays. Since DSCR lenders focus on the value of the property and the expected cash flow of the property, plus the quality and depth of your credit, there is far less necessary documentation. Most DSCR lenders will not ask you for documentation to verify your employment, income or assets (beyond required liquid reserves).
Why Investors Should Consider DSCR Loans
DSCR loans work by calculating the Debt Service Coverage ratio, which identifies whether a property can cover its own debts. The rental income is divided by PITIA (Principal, Interest, Taxes, Insurance, Association dues) to develop a ratio.
If the ratio is above 1, this means that it is covering all of its debts and breaking even, while if it is below 1, the rental property is losing money. Lenders typically seek a DSCR of 1.2 or higher, meaning that the property is generating 1.2 times its debts through rental income.
DSCR Loan Requirements
Minimum Credit Score Required
Most DSCR lenders require a 680 credit score with better rates for higher credit. Most lenders also have minimum tradeline requirements, including both amount and duration. Lenders also will consider whether you have any other significant credit events on your credit report, such as foreclosures, bankruptcies, or past-due payments.
Minimum Down Payment or Equity
Maximum loan-to-value on purchase loans typically is 70–80%; on refinances, 65–75%, depending on property type, credit, and DSCR.
Minimum Property Value
Most lenders have a minimum property value of $150k.
Minimum Loan Amount
A good minimum standard is $75k.
DSCR Loan Use Cases
Cash-Out Refinance Loan
Cash-out refinances are our most popular use case. A cash-out refinance is when you replace your mortgage loan with a new loan for a higher loan amount, and the difference in cash is yours. You could also obtain new financing on a property that is not currently pledged on a loan. Our clients use our cash-out refinances to:
- Renovate an existing rental
- Buy another investment
- Finance a flip
Rate & Term Refinance
A rate & term refinance is when you refinance an existing loan in order to change the interest rates and/or terms of the loan. Commonly, investors will use a hard money loan or a fix and flip loan to purchase and renovate a distressed property. Once the renovations are complete, they will keep the property as a rental and refinance into a DSCR loan for permanent financing.
Purchases
A purchase is when you buy a new property. Investors will you a purchase loan to:
- Purchase already rented properties
- Purchase rent-ready properties
Vacation Rentals
Unlike other lenders, Visio has been able to make sense of short-term rents and will finance vacation rentals. Our investors often will use our DSCR Loans to:
- Cash-out refinance a vacation rental to buy more properties
- Cash-out refinance a vacation rental to buy more properties
- Purchase a new vacation rental as an investment
DSCR Loan Use Cases
A debt service coverage ratio of 1.2 is solid, and anything above 1.5 is strong. A DSCR of 1 indicates the rent exactly equals the monthly sum of principal, interest, taxes, insurance, and association dues (if any). With a debt service coverage ratio below 1, the investor will be subsidizing the PITIA with cash from other sources.
Let’s look at some examples for a clearer picture.
DSCR Examples
DSCR < 1
- Principal + Interest= $1,800
- Taxes= $250
- Insurance= $150
- Principal + Interest= $1,800
- Association Dues=$35
- Total PITIA= $2235
- Rent= $2100
- DSCR= Rent/PITIA=2100/2235=0.94
Since the DSCR is .94, we know the PITIA is greater than the monthly rent from the property, indicating negative cash flow.
DSCR = 1
- Principal + Interest= $1,500
- Taxes= $350
- Insurance= $150
- Association Dues=$100
- Total PITIA= $2100
- Rent= $2100
- DSCR= Rent/PITIA=2100/2100=1.00
Since the DSCR is 1.0, we know the mortgage payments and PITIA expenses are equal to the monthly property rent
DSCR > 1
- Principal + Interest= $1,600
- Taxes= $250
- Insurance= $150
- Association Dues=$35
- Total PITIA= $2,035
- Rent= $2,350
- DSCR= Rent/PITIA=2350/2035= 1.15
If we divide the rent by PITIA, we get a DSCR of 1.15, which indicates positive cash flow.
Optimizing The DSCR
Simply put, the debt service coverage ratio is a ratio, and it can be manipulated by changing the numbers. Here are ways to improve your DSCR:
Charge More Rent
One surefire way to improve your DSCR, is to charge more rent for your rental property. An increase in rental income will give you more cash flow to pay your monthly mortgage payments, and therefore improve DSCR.
Lower Your Interest Rate
Lowering your interest rate will lower your monthly mortgage payments and therefore your DSCR. The best ways to guarantee a lower interest rate are to increase your down payment and improve your credit score. For help optimizing a DSCR ratio, check out our DSCR calculator.
Negotiate Your Taxes and Insurance
Other key debt obligations in the DSCR formula are taxes and insurance. Be sure to shop insurance providers for the best rates, though never compromise on coverage. You should also fight your property taxes annually to continue to lower your total debt service.
Why Is My Debt-Service Coverage Ratio Low?
Just like you can optimize the DSCR ratio, there are some factors that could lower your DSCR ratio. DSCR lenders usually require a DSCR of 1.2 or more. You may qualify initially for a DSCR mortgage, and then have some numbers come back higher or lower than you were expecting. Knowing about these DSCR surprises upfront can help investors be extra cautious when calculating DSCR to guarantee positive cash flow.
Higher than Expected Insurance
If the cost of insurance you calculated in your initial debt-service coverage ratio comes back higher, your monthly expenses will increase and therefore lower your DSCR ratio, cash flow, and ability to qualify for a loan.
Higher than Expected Taxes
Similar to an increase in insurance, an increase in property taxes will increase your monthly expenses and, therefore, your debt-service coverage ratio.
Lower than Expected Rental Income
Frequently, we see a property being leased for a rent that is higher than market value. When an investor lowers their rent and rental income, the debt-service coverage ratio goes down.
Prepayment Penalties
While this is not a surprise that will impact your ability to qualify for a DSCR mortgage, a prepayment penalty is a feature of most DSCR loans that you don't want to be a surprise. A prepayment penalty is a contractual clause that states the borrower is going to pay the lender an additional fee if the borrower pays the loan off early. This isn’t necessarily a “penalty,” however. Here's how it works.
A common prepayment penalty structure — and in fact, Visio’s standard structure — is called a 5/4/3/2/1 structure. This means that if the borrower pays off the loan in year one, they have a 5% prepayment penalty, in year two, a 4% prepayment penalty, and so forth. If your prepayment penalty structure is a 3/0/0, it means that in the first year you pay a 3% fee, and then the penalty goes away after that. The reason the term "penalty" is not accurate is because it does not necessarily impact your DSCR loan. For instance, investors looking to hold onto their properties long-term are not impacted by the prepayment penalty. Investors who want more flexibility can take a higher interest rate to get rid of their prepayment penalty entirely.
What DSCR Is Missing
So we talked about what could lower or raise your debt-service coverage ratio, but believe it or not this is not the whole picture. Yes, you are looking at net operating income compared to debt obligations, but if you think about it an investor’s monthly payments often comprise of more than just PITIA. While DSCR loans require a 1.2, there are more payments that need to be taken into consideration for the full picture of cash flow for any given property.
Property Management Expenses
With a portfolio of investment properties naturally comes general maintenance and repairs. This is not necessarily a monthly expense, however it is still important and can reflect your total debt service for the year. We recommend having savings set aside specifically for this purpose.
Vacancy Rates
"Vacancy" might as well be a curse word for a real estate investor. A vacancy means no rental income to assist with your mortgage payment. Again, we recommend every real estate investor have substantial savings to help them build their real estate portfolio. It also good practice to have Rent Loss Insurance to assist with rental income in the event of a vacancy.
Tenant Costs
The list of expenses for real estate investors goes on and on. Investment properties need tenants, which means marketing, advertising, screening, and contracting. These are not recurring expenses, yet still they can add up and impact your net operating income annually.
Income Taxes
A great thing about DSCR loans is that they don't look at your personal debt or income. However, on your annual tax returns you are going to have to include rental income. Fortunately, there are great tax deductions for landlords.
Our goal in highlighting these prevalent real estate investor costs is to show that a fantastic DSCR ratio does not mean automatic success. It is important to consider a complete picture of your debt obligations before obtaining a DSCR loan. If you think you are ready to apply for a DSCR loan, keep reading for requirements and what to look for in a DSCR lender.
Furniture
If you are using a DSCR product to purchase a vacation rental, the DSCR calculation does not take into consideration all of the furniture you have to buy for the property. Not to mention the dishes, bedding, electronics, etc. needed to get a vacation rental property up and running.
Our goal in highlighting these prevalent real estate investor costs is to show that a fantastic DSCR ratio does not mean automatic success. It is important to consider a complete picture of your debt obligations before obtaining a DSCR loan. There are also some scenarios where a DSCR loan will not be a good fit. We'll get into that in the next section and then if you think you are ready to apply for a DSCR loan, we'll discuss the requirements and what to look for in a DSCR lender.
When a DSCR Loan is Not a Good Fit
Debt-Service Coverage Ratio is a powerful tool for real estate investors looking to build a portfolio of investment properties. However, DSCR loans are not ideal for everyone. Here are some examples of when you would not use a DSCR loan:
You're Purchasing Your Primary Residence
DSCR Loans can only be used to purchase an investment property. For your primary residence, you should stick with conventional mortgages.
You're Purchasing Your First Investment Property
Many real estate investors are able to obtain conventional mortgages on their first rental. The interest rates will be lower and first time investors often have the income and documentation needed to meet the debt-to-income ratio qualifications for conventional mortgages. However, conventional mortgages can only be financed in your personal name. If real estate investors want to protect their personal assets by focusing entirely on their company's cash flow, sometimes they will obtain a DSCR mortgage for their first investment property so they can finance through an LLC.
You're Purchasing a Distressed Investment Property
Most DSCR loans require rent-ready rental properties. That means no construction projects or anything more than minor wear and tear. Many real estate investors looking to flip an investment will finance their construction through a hard money loan program and then refinance into a DSCR product for permanent financing.
The Rental Income is Lower than the Mortgage Payments
If you are purchasing an investment property in a hot market where the rents have not caught up to the home prices, you will not be able to cover the monthly debt payments with rental income, especially due to high DSCR loan interest rates. Most lenders require at least a 1.2 DSCR and will not loan to you if you are unable to meet the monthly debt payments. However some lenders, like Visio, have a No DSCR Loan Program for this reason. We see the value in investing in hot markets, and will offer you a No DSCR Loan if you have a strong credit report and meet other qualifications.
The Investment Property is Low Value
Most lenders have a minimum amount of $75k and a minimum property value of $150k. Even if the rental income will cover the monthly mortgage payments, you likely will not qualify for loans based on DSCR if you don't meet the other minimum requirements. One way real estate investors pay for this kind of property is to use a DSCR product to pull cash out of another investment property.
What To Look For In A DSCR Lender
When comparing DSCR loan lenders, here are some considerations.
What are the lenders rate and fees?
It is important to know exactly what your costs will be for the loan. The last thing you want is to end up at the closing table with unexpected costs. Most lenders charge an origination fee and one or more administrative fee (underwriting fee, documentation fee). Also be on the lookout for a prepayment penalty if you are looking to sell the property in the near future.
What are the lender’s eligible property types?
This may seem obvious, but it does vary between lenders. For instance, some lenders have DSCR Loan Programs for vacation rentals and others do not. Other common variations include warrantable vs. non-warrantable condos and multi-family vs. single-family homes.
Is the lender focused on and experienced in working with investors?
In our opinion, this is the most important consideration. Lenders who work with investors often understand the nuances associated with financing and have programs tailored to help investor needs. There are a lot of new DSCR lenders on the market. Here are some things you can look for to help hone in on the most experienced lenders: Ask about the number of DSCR loans they have closed Ask how long they’ve been offering and closing DSCR loans Ask whether they have a dedicated team of operations personnel that process and underwrite their DSCR loans Ask about their property insurance requirements, because they typically are materially different for investment properties as compared to owner-occupied properties
- Ask about their prepayment penalty or rate buy-down options. DSCR loans almost always have a prepayment penalty
- Ask about the ability to finance in an LLC or corporate entity
- Ask whether they have a dedicated team of operations personnel that process and underwrite their DSCR loans
- Ask about their property insurance requirements, because they typically are materially different for investment properties as compared to owner-occupied properties
- Ask about their prepayment penalty or rate buy-down options. DSCR loans almost always have a prepayment penalty
- Ask about the ability to finance in an LLC or corporate entity
Why You Should Partner with Commercial Quick Loans for Your DSCR Loans
Financing DSCR loans requires specific expertise and differs from other loans in terms of the following:
Underwriting requirements
As an example, personal income history is not a consideration when underwriting DSCR loans.
Appraisal process
For a debt-service coverage ratio loan, an evaluation of comparable rents in the area is needed in addition to the standard property appraisal report. This will estimate the property’s cash flow to calculate the DSCR.
Borrower types
Often, a real estate investor finances properties in an entity, which in itself has some lending nuances. For instance, there are necessary entity documents. This is just a sampling of the many nuances associated with a DSCR mortgage. Visio Lending has over a decade in mastering this niche market with over $2.5 billion in DSCR Loans originated, including more than $750 million in vacation rentals