If you invest in real estate and have a property that is cash flowing, then the DSCR loan may be right for you.  DSCR stands for Debt Service Coverage Ratio and is basically a loan that is provided more based on the income of the property that is being bought (or refinanced) versus the income of the borrower.  DSCR loans are mainly for residential types of investment real estate.  This article explains the pros and cons of DSCR loans to help real estate investors make the best choice.

Who is the DSCR Loan Best For

As mentioned above, a DSCR loan is for residential real estate investors looking to leverage the income of their property to qualify for the loan as opposed to their own personal finances.  By using the property income to qualify for the loan, investors do not have to worry about their own income or debt to income ratio impacting their ability to get a loan.  The investment property in question must meet the minimum requirements of the lender in terms of the value of the property and the minimum rent required which is discussed further below.

While borrowers of the DSCR loan can get 30-year fixed term, the interest rate is going to be higher than a typical conventional 30-year mortgage meant for residential investment real estate (1-4 rental units in the building).  Typically, lenders are providing DSCR loans for a building that has at most four units.  Some lenders may also have DSCR loans for buildings in the 8 to 10 unit range.  There are DSCR loans available as well for mixed use buildings where a majority of the space is for residential space and a small amount of commercial space.

It pays to shop around and check with different lenders to compare rates and fees associated with the DSCR loan.  Not every lender is the same and the DSCR loan products will vary by lender.  Real estate investors should connect with other investors and check with whom they have had success with for their DSCR loans. Investors can also ask their real estate agent and current lender for lenders who offer DSCR loans.

DSCR loans will have higher interest rates than the conventional 30-year fixed mortgage interest rate (non-owner occupied).  Typically, DSCR loan borrowers will see a 0.5% to 1.5% higher interest rate than with a conventional mortgage.  It pays to shop around not only for rates but also for the fees charged by the lender for the DSCR loan.

DSCR Loan Requirements

Coverage Ratio

The debt service coverage ratio is the amount of rent the lender will be looking for in relation to the debt service.  Debt service refers to the amount of debt being paid back and typically consists of loan principal, interest, taxes and insurance.  Often DSCR lenders will have a DSCR coverage ratio requirement of 1.25 or higher.  What that means is after the total net operating income (NOI) is divided by the total debt service, the resulting number should be 1.25 or higher.

If the number is lower than 1.25 the lender can deny the loan, require a lower loan to value (LTV) amount (borrower has to put more money down), charge a higher interest rate, or require increased cash reserves.  With these loans the lender also will require that the borrower provide updated rent rolls, operating statements and/or lease agreements on an annual basis to verify that the 1.25 or higher number is still applicable.  

If later during the loan period the number drops below 1.25 the lender can require the borrower to pay more from the rent to the lender so they can build up a reserve fund in case of default.  The lender can also increase the interest rate charged in the loan, require the borrower to pay to the lender additional cash to reduce the LTV, or declare the loan in default and foreclose on the property.  What the lender ultimately can do when the DSCR number is below 1.25 depends on the terms and conditions written into the loan agreement.

Credit Score

DSCR lenders will consider borrower credit score during the application process.  While the primary focus of the DSCR loan application will be the property income, a higher credit score that the borrower has usually means a lower interest rate.  Below a certain credit score a DSCR loan will not be approved.  Different lenders will have different credit score requirements so ask up front before going through the credit pull process of the application.

Appraisal

DSCR lenders will want to see an LTV of 75-80% and will usually require an appraisal of the property.  The appraiser will not only provide an opinion of value of the property they will also verify the property’s income potential.  Income potential can be provided based on current rents, market rents in the area and/or rent history of the property.

DSCR Refinance

One can refinance a conventional mortgage to a DSCR loan and also refinance a DSCR loan for a lower rate and to access equity.  Most investors probably don’t want to refinance from a conventional mortgage to a DSCR since the interest rate will be higher on the DSCR loan.  With conventional mortgage though there is a limit as to how many an individual can have in their name, therefore refinancing into a DSCR to have access to a conventional mortgage might make sense when the numbers make sense.

For those with an existing DSCR wanting to refinance to get a lower interest rate they should check if their loan has a pre-payment penalty.  Sometimes with a pre-payment penalty it may not make sense to refinance for a lower rate as the fees with closing on a new loan and paying a pre-payment penalty on the existing loan may not lead to a positive return on investment.  Many lenders offer DSCR loans with a cash out option allowing the investor to pull out cash from their property (within lender LTV limits) and use that cash elsewhere.  Cash out DSCR loans usually will have a more strict requirements as compared to just a DSCR refinance.

Final Thoughts

DSCR loans represent an easy way to get into real estate investing without having to worry about one’s personal income resulting in a declined application.  Want to learn more about the DSCR loan products for your 1–4-unit Ohio residential real estate investment?  Be sure to reach out to me for a no obligation consultation to see if our DSCR loan product meets your needs.