Debt Coverage Service Ratio Loans (DSCR): The Requirements and Application ProcessAugust 31, 2022 by X2 Mortgage
With the outstanding growth rate of the real estate market, particularly rental properties in the United States, an increasing number of mortgage lenders and financial institutions are trying to devise easier methods to make the acquisition of real estate holdings less difficult for investors. And one of the unique options created is the Debt Coverage Service Ratio (DSCR) Loan.
The term Debt Coverage Service Ratio (DSCR) is not exclusive to real estate; it is also used in other industries and commercial financing transactions to refer to "metrics used to determine whether a company has enough operational cash flow to repay its debts."
However, in real estate, it is used to examine if a real estate (rental) property generates adequate net income to satisfy existing and anticipated mortgage obligations. If you're looking for a way to finance your next home purchase without putting yourself at risk, then read on. We'll explain everything you need to know about debt coverage service ratio loans.
What is the Debt Service Coverage Ratio (DSCR) Loan?
A DSCR loan is an investment property mortgage that qualifies a borrower based on the predicted rental income of the property rather than their personal income or debt.
To establish the borrower's eligibility for the loan, the lender calculates the DSCR of a rental property using rent revenue or expected rent income derived from a property appraisal report.
This loan is designed for Real Estate Investors and Mortgage Brokers who do not want to use their income tax returns to qualify for a loan to purchase an investment property.
How Does a DSCR Loan Work?
The debt service coverage ratio (DSCR) in real estate is a metric used to assess a property's performance. It compares a property's cash flow to its debt payments and determines if the property can produce enough net operating income (NOI) to cover a proposed mortgage.
If the DSCR is greater than "1", it means the property generates an annual operating revenue equal to the yearly debt payment. Conversely, a DSCR of less than one is typically deemed financially unhealthy for both the lender and the investor.
In a DSCR loan, the lender uses the coverage ratio to qualify borrowers. It usually is part of the underwriting process and involves analyzing the net cash flow on the proposed property to establish the maximum loan amount the borrower/investor is eligible for.
An investor may also use the DSCR to evaluate the financial performance of the present rental property to refinance an existing mortgage or use the DSCR to assess the prospective net cash flow generated by an investment property for the purpose of a new loan.
The higher the DSCR, the lower the loan risk for the lender and investor. As a result, each lender has different ratio criteria that an investment property must have to qualify for a DSCR loan.
How Do You Calculate the Debt Service Coverage Ratio (DSCR)?
Calculating the debt service coverage ratio (DSCR) in real estate is quite simple. A property's net operating income (NOI) is divided by the annual loan payment.
The calculation is as follows:
DSCR = Net Operating Income (NOI) / Annual Debt Payment.
For example, if Mr. Borrower is seeking to buy an investment property with an NOI of $20,000 and an annual mortgage payment of $16,000.
The DSCR is calculated as follows: $20,000 (NOI) / $16,000 (Annual Debt Payment) = 1.25.
This means that the property generates 25% more money than is required to cover his annual mortgage payment. This is considered an excellent investment.
So, how do you calculate a property's Net Operating Income?
Net operating income is defined as all money earned by a property minus all operating expenditures. Here is what you need to know to calculate your Net Operating Income;
NOI = Gross Annual Income - Annual Operating Expenses
A single-family rental home's gross annual income might include, among other things, monthly rent, utility costs, and appliance rent.
The rental home could have the following annual operational expenses: annual repair and maintenance costs, property management fees, property taxes, utilities, insurance fees, and an average annual vacancy rate.
The appraiser will subtract all operational expenses from gross annual income to calculate its net operating income.
- In addition, the annual Debt Payment is calculated as the Principal and Interest Payment.
What Is a Good DSCR?
Lenders typically want a DSCR of at least 1.25 to grant a loan. This is because a DSCR of "1" indicates that a property earns just enough operational revenue to cover its mortgage payment. And due to economic volatility, there is no certainty that such property will be able to service the loan obligation for an extended period of time without defaulting.
Whereas a property with a DSCR of 1.25 or higher earns more than enough revenue to cover its annual debt. That is, after paying its annual mortgage, there is still enough money left over, implying that there is a low chance of default.
However, a borrower may still be able to obtain a loan with a DSCR of "1" or even below at what lenders call a "No Ratio DSCR Loan". To obtain a DSCR ratio that is at or below "1", typically a lender wants to see reserves (cash in the bank) or good rental history on other properties.
What are The Requirements to Qualify for A DSCR Loan?
Lenders typically want a DSCR of at least 1.25 to grant a loan. However, a DSCR of 1 or below can be granted on a case by case basis. Since there's so much fluctuation in how the calculation can be done, it's broken down as follows:
The coverage ratio is the most essential requirement for a DSCR loan. If this is a refinance loan, then the DSCR is calculated based on the income figures over the last 2 years. If this is a purchase, then the figures and calculations are heavily based on the appraisal that is done on the property during the process.
As previously stated, the individual lender decides the minimum coverage ratio, which can be as low as "no ratio" or a negative cash flow. The macroeconomic situation of your area may also influence the coverage ratio, and the larger the down payment or equity in the property, the better your chances at getting approved for a no ratio DSCR loan.
To qualify for a DSCR loan, you must have a decent credit score. Most lenders will accept credit scores as low as 620 FICO though.
Minimum Down Payment
To qualify for a DSCR mortgage, lenders normally require a 20-25% down payment (equivalent to 75-80% maximum LTV). Other closing costs might include an appraisal fee, an origination fee, a lender fee, and a service fee.
You can use a DSCR loan to finance an investment property, such as an office building, hotel, resort, or rental residence. This loan allows you to finance multiple rental properties and expand your real estate investment portfolio.
The lender determines the amount of money a borrower can get through a DSCR loan. Most lenders provide up to $3 million, which is significantly more than the maximum loan amount available in a regular mortgage program.
How to Apply For A DSCR Loan
1. Talk to a Lender
Private lenders provide most DSCR loan programs. You may also work with a mortgage broker, like X2 Mortgage, to find a suitable lender as they work with numerous private lenders to get you the best deal. Once you've started working with a lender, go through all aspects of the loan, including the loan's value, terms, and fees.
2. Underwriting Process
This is the stage where your lender determines your eligibility. First, a property appraisal is ordered, and a professional appraiser conducts a standard appraisal on the property using a Market Rental Analysis of comparable properties in the area. The report is then compared to your new loan's estimated yearly mortgage payment to calculate your DSCR.
At this stage, you are required to complete the standard documentation for DSCR loans. By its design, a DSCR loan requires only information about your business or rental property, not your personal income history.
4. Submission and Closing
Because you do not need to disclose details about your personal financial history, the application procedure for a DSCR loan is fairly quick and uncomplicated.
Once your loan is approved, your lender will present you with a loan estimate that includes the interest rate, monthly payment, and closing fees. Next, you are required to review the loan terms and submit your acceptance letter.
The lender then sends you a commitment letter, followed by payment of closing costs and the signing of all closing documents.
Pros and Cons of DSCR Loans
Like every mortgage program, DSCR loans have their benefits and drawbacks. So, let's have a look at some of them.
Larger Loan Amount: DSCR is specifically developed for real estate investors to provide them with more liquid financing than is available through traditional mortgages. As a result, a borrower can obtain a loan of up to $3 million to purchase an investment property.
Multiple Loans and Properties: Unlike traditional mortgages, there is no limit to the number of properties that can be funded or the number of DSCR loans that can be held at the same time. This allows you to expand your real estate investment.
Easier to Qualify: Unlike other loans where your personal income information, such as paystubs and tax returns, is used to establish your eligibility, loan amount, and interest rate, DSCR loan only uses the cash flow of the property, making them easier to qualify for.
Faster Closings: Because borrowers are not needed to submit personal income verification, the application process is usually simpler and faster than traditional mortgages.
Limited Access: DSCR loans are not designed for primary home buyers. As a result, only real estate investors are eligible for the loan.
Loan Term: A larger down payment and a higher interest rate are usually required by lenders than with a standard mortgage. A DSCR interest rate is often 1-2% points more than a regular mortgage.
Prepayment Penalty: If you pay off, sell, or refinance your DSCR loan within a few years, you may face a prepayment penalty of thousands of dollars. So, before applying, check with the lender and read all loan terms.
A DSCR loan is a wonderful option if you want to buy an income-producing property. You don't need to fulfill income, debt, or employment requirements to acquire the loan because it does not require your personal income information. Once the property meets the coverage ratio, you are qualified to get the loan.
However, before proceeding with this loan, we advise you to consult a legal and accounting professional to assist you with the most crucial components of the loan and property management. It will save you money in the long run.