Debt Service Coverage Ratio (DSCR) loans allow borrowers to qualify for a loan solely based on the cash flow generated by their investment property, rather than on their personal income. DSCR loans are an excellent way to fund your real estate investment deals.
Financing an investment property with a DSCR mortgage can also be more cost-effective than commercial loans. However, there are some disadvantages to this type of loan that should be considered.
How Does DSCR Work?
Lenders will evaluate your DSCR before making a loan. A DSCR of less than one indicates negative cash flow, which suggests that you won’t be able to meet or pay current debt commitments without using outside resources—in other words, borrowing more.
A DSCR of 0.95, for example, suggests that net operating income is only enough to repay 95% of yearly debt payments. This means that you would have to take from your personal funds every month to keep the project afloat. Lenders usually frow upon negative cash flow. However, some may allow it if you have substantial assets in addition to your income.
If your debt-service coverage ratio is too close to 1, you’re considered to be vulnerable and even a little drop in cash flow could cause you to default on your loan. Lenders usually demand you to maintain a particular minimum DSCR while the loan is outstanding in some instances. If you fall below that minimum, you may be considered in default under several agreements. A DSCR that’s higher than 1 indicates that you have enough income to meet your present debt obligations.
Pros of DSCR Loans
DSCR loans provide great flexibility, allowing real estate investors to find alternative ways to fund their projects. Here are the top three benefits of DSCR loans you should have in mind.
Lenders Don’t Consider Personal Income
One of the significant advantages of a DSCR loan is that it does not require employment verification, disclose any leases, or present proof of income. Instead, the lender is only interested in the cash flow generated by the subject property.
DSCR Loans Can Offer Quicker Closing Times
While loan processors and underwriters typically examine your paystubs and conduct background checks on your employment history, these steps are skipped in the DSCR process. This results in a faster close than with commercial loans.
You Can Commit to Several Properties at Once
Some loans require you to make a one-time commitment to a single property. You won’t be able to get a loan for a second property until you’ve paid off your first. However, that’s not how DSCR loans work. You can take out many loans for different properties simultaneously to scale your business faster.
Cons of DSCR Loans
Despite the great flexibility of DSCR loans, you should consider some potential downsides before deciding.
The down payment needed can range from 20% to 25%, depending on the lender. Additionally, you’ll need to pay lender and service fees, ranging from 0.5% to 1% of the entire loan. DSCR mortgage rates are typically 1.000% to 2.000% higher than rates on traditional loans. If there is no lease on the property and the estimated rental revenue is based on an appraisal report, the interest rate may be higher.
Even though DSCR rates and terms are comparable to other types of loans, they provide more limited financing. So if you need more than $5,000,000, DSCR loans might not be your best option.
The usual method of determining whether or not you qualify for a mortgage loan is to look at your income and make sure that you earn more than the mortgage payments and costs. This is a difficulty for self-employed investors who can’t prove their income and those who are creating a significant rental portfolio. Even if an investor has a high-paying career, their money debt payments may outpace their personal gain if they own many mortgaged rental properties.
DSCR loans allow you to separate your business and personal affairs, don’t dig as deeply into personal records as other loan products, and have a faster closing time than other loan products. On the other hand, you should expect slightly higher down payments, mortgage rates, and less overall financing. So, while no loan is perfect, the DSCR is an appealing alternative for real estate investors.