DSCR Loans: Definition, Pros and Cons

As a real estate investor, financing can be one of the biggest challenges you face in securing properties, particularly short-term rental properties. Conventional loans can be hard to qualify for, and if you are self-employed, it can be very difficult to satisfactorily document income to lenders. And while private or hard money can work, it can be a fairly intimidating process. However, there is a loan option that may suit you, and its popularity is rising amongst real estate investors, the DSCR loan.

A DSCR loan, also known as a debt service coverage ratio (DSCR) loan can be a viable and excellent option for investors. In this article, we will explore what DSCR loans are, who they are best suited for, and the pros and cons of taking one out for your next real estate investment. Understanding DSCR loans and how they can work for you could be an important cog in scaling your real estate empire.

What is a DSCR Loan?

A DSCR loan is a type of real estate business loan that uses the debt service coverage ratio to determine whether the borrower can afford to make loan payments. In essence, this ratio calculates the amount of cash flow available to pay off debts after necessary expenses such as taxes and mortgage payments have been paid. DSCR loans are popular with real estate investors who may have challenges getting approved for conventional loans.

Who are DSCR Loans Best Suited for?

DSCR loans are best suited for investors who are looking to purchase income-producing properties. This type of loan is ideal if you plan to use the property as a source of income, primarily if you intend to rent it out. DSCR loans are also for borrowers with relatively low credit scores who may not qualify for traditional loans due to their lower credit score or problems with their credit history. Additionally, DSCR Loans work well for self-employed individuals, or individuals who take advantage of extensive tax write-offs, which reduces annual income.

DSCR loans are growing in popularity due to many factors, including that much less personal documentation is required vs. a conventional loan. Understanding DSCR loans also can help investors secure good cash-flowing properties when they otherwise might not qualify.

How Do You Calculate a DSCR Loan?

Calculating a DSCR loan involves a relatively simple formula. The Debt Service Coverage Ratio (DSCR) is calculated by dividing the Net Operating Income (NOI) by the total debt service. Here’s a closer look at how this works:

Net Operating Income (NOI): This is the income generated from the property after deducting all operating expenses. Operating expenses can include property management fees, repairs, insurance, taxes, and utilities. However, it does not account for any mortgage payments or other loan costs.

Total Debt Service: This refers to the annual repayments made on the loan. It includes both principal and interest.

To calculate the DSCR, you’ll divide the NOI by the debt service. If the resulting number is higher than 1, it indicates that the property generates enough income to cover the debt payments. A DSCR of less than 1 suggests that the property’s income is insufficient to cover the debt service, posing a higher risk to lenders.

For example, if a property has an NOI of $120,000 and the total debt service is $100,000, the DSCR would be 1.2. This suggests that the property generates enough income to comfortably cover the loan repayments.

It’s important to note that different lenders may require different DSCRs. Typically, a DSCR of 1.2 is considered acceptable, but some lenders may require a ratio of 1.25 or higher. Conversely, we’ve seen some lenders who will approve a 1.0 ratio.

What Is Needed to Qualify For a DSCR Loan?

To qualify for a DSCR loan, lenders typically look at several key factors. First, they consider the DSCR, which should ideally be over 1.2, unless specified otherwise by the lender. This ratio proves that the property is generating enough income to comfortably cover loan repayments.

Second, the property’s market value and the equity the investor has in the property are evaluated. Lenders may require a property appraisal to ascertain its current market value. The equity an investor has in the property serves as security for the lender and can influence the loan’s approval and its terms.

Third, the investor’s credit score is considered, although DSCR loans are more forgiving of lower credit scores compared to traditional loans. Your credit history doesn’t need to be perfect, but severe infractions like bankruptcy or foreclosures could adversely impact loan approval.

Fourth, lenders may look at your overall financial stability, including cash reserves and the ability to cover loan repayments if the property fails to generate sufficient income in the short term.

Finally, lenders assess the property’s income potential. They consider factors such as location, condition and profitability of similar properties in the same area. The property should ideally have a strong income potential as it is the primary source for loan repayment.

In summary, while qualifying for a DSCR loan is more flexible than other types of loans, it’s crucial to demonstrate strong property income potential, reasonable credit history, and overall financial stability.

Do DSCR Loans Require a 20% Downpayment?

It’s a common misconception that all DSCR loans require a 20% down payment. The reality is that the down payment requirement varies significantly based on the lender and the specific circumstances of the borrower and the property in question. Some lenders may require a 20% down payment, while others might require 30% or more, particularly for investors with lower credit scores or for properties that are deemed higher risk. Our experience with DSCR loans has been that 25% downpayment is pretty standard.

However, some lenders offer more flexible down payment requirements, which can be less than 20%, particularly for investors with a strong credit history and properties with solid income potential. It’s crucial to note that the more substantial the down payment, the lower the loan-to-value ratio, which can potentially lead to more favorable loan terms. Therefore, it’s always important to review the specific down payment requirements with potential lenders before proceeding with a DSCR loan.

Do DSCR Loans Require a Credit Check?

Yes, DSCR loans typically require a credit check. While the emphasis of DSCR loans is on the income generated by the property, most lenders will still conduct a credit check to assess the borrower’s financial history and reliability. The credit check provides insights into the borrower’s past behavior concerning debt repayment and financial management. However, compared to traditional loans, DSCR loans can be more accommodating of lower credit scores.

The borrower’s credit score is generally a less critical factor as the central focus of the loan approval process is the property’s capacity to generate enough income to cover the loan payments. Still, a significantly low credit score or severe negative items on a credit report can potentially affect the loan approval process or result in less favorable loan terms. It’s also important to remember that every lender may have different criteria and policies concerning credit checks and minimum acceptable credit scores.

Our experience has shown that a DSCR loan interest rate will vary depending on your credit score. For example, a score of above 720 will typically garner a lower interest rate than a score between 700 – 719.

Can I Live In a Home Bought With a DSCR Loan?

The short answer is no. Typically, DSCR loans are intended for investment properties – those that generate income through rent or lease. Therefore, most lenders do not permit the borrower to live in a property purchased with a DSCR loan as it is meant to be a source of income, not a primary residence.

However, some exceptions may apply depending on the lender’s policies. For instance, you might be permitted to live in one of the units if you purchase a multi-unit property. It’s crucial to understand the lender’s rules regarding owner occupancy before purchasing a property with a DSCR loan. Always consult with your lender or a knowledgeable real estate attorney to ensure compliance with all terms and conditions.

Can An LLC Take Out a DSCR Loan?

Yes, a Limited Liability Company (LLC) can indeed take out a DSCR loan. In fact, it’s quite common for real estate investors to purchase property under an LLC and subsequently secure a DSCR loan. The primary reason for this is the legal protection it offers. If the property were to face any legal issues, the investor’s personal assets would be protected because the property is under the LLC, a separate legal entity. Furthermore, applying for a DSCR loan under an LLC can sometimes make the loan approval process smoother, especially if the LLC has a strong rental income history.

However, lenders may still require personal guarantees from the LLC members, especially if the LLC is new or lacks adequate financial history. It’s crucial to consult with a professional advisor or attorney to understand all the nuances involved before moving forward.

Can You Refinance a DSCR Loan?

Yes, refinancing a DSCR loan is a possibility and can be a strategic move for investors looking to leverage better interest rates, alter the loan terms or free up cash from their property’s equity. The primary consideration during refinancing is still the Debt Service Coverage Ratio. The investors must demonstrate that the income generated by the property can comfortably cover the loan repayments under the new terms. It’s vital to consider the costs involved in refinancing, such as prepayment penalties on the existing loan and closing costs on the new loan.

Investors should weigh these costs against the potential benefits of refinancing, like lower monthly payments or shorter loan terms.

Can You Use a DSCR Loan for a Short-Term Rental?

Yes, it’s possible to use a DSCR loan for a short-term rental property, such as those listed on platforms like Airbnb or VRBO. These types of rentals can often generate higher income than traditional long-term rentals, which could potentially make them attractive to lenders. However, there are a few caveats. Some lenders may be reluctant to approve a DSCR loan for a short-term rental due to the perceived higher risk associated with this type of property. Unlike long-term rentals, income from short-term rentals can be more volatile due to factors such as seasonal demand and market competition. Therefore, lenders may require a higher Debt Service Coverage Ratio to offset the additional risk.

Moreover, local laws and regulations about short-term rentals can influence the lender’s decision. It’s crucial to communicate openly with potential lenders about your plans for the property and understand all terms and requirements before proceeding.

Are DSCR Loans More Expensive Than Conventional Loans?

Yes, DSCR loans can carry higher interest rates than conventional mortgages. This is primarily due to the nature of the loan itself – DSCR loans are generally considered riskier by lenders as they focus on the property’s income rather than the borrower’s personal income. Therefore, lenders often mitigate this risk by charging higher interest rates.

Additionally, DSCR loans can often involve more substantial closing costs and fees, further contributing to their overall cost. However, it’s important to note that the exact costs will depend on various factors, including the lender’s policies, the specifics of the loan deal, and the property’s financial performance.

How Long Is a DSCR Loan Term?

The term of a DSCR loan can vary significantly depending on a range of factors such as the lender, the specifics of the loan arrangement, and the performance of the property. However, typical DSCR loans can have terms ranging from 5 to 30 years. Shorter terms often come with higher monthly payments but lower total interest costs, whereas longer terms may have lower monthly payments but higher total interest costs over the life of the loan. The choice of loan term would ultimately depend on the borrower’s financial circumstances, investment strategy, and cash flow projections. As always, it’s recommended to consult with a professional advisor or lender to understand the implications of different loan term options.

Advantages of DSCR Loans

DSCR loans carry several advantages that make them an appealing option for many short-term real estate investors. One of the most significant benefits is the flexibility in underwriting. Unlike traditional loans, which heavily rely on the borrower’s personal financial strength, DSCR loans focus on the income potential of the property. This is particularly beneficial for investors with strong rental properties but weaker personal finances.

Another advantage is the potential for higher loan amounts. Since lenders base the loan value on the property’s income, investors may have access to larger loans than they would with other loan types. This can be crucial in investment real estate, where properties often come with higher price tags.

Additionally, the repayment terms of DSCR loans can offer more flexibility. Because the loan is based on the property’s income, you may not be required to start making repayments until the property starts generating revenue. This can provide valuable breathing room for investors, particularly in the early stages of their investment.

Lastly, DSCR loans can be used for virtually any type of business real estate property, including retail spaces, office buildings and multi-family residences. This versatility makes DSCR loans a versatile tool in an investor’s financial toolkit.

Disadvantages of DSCR Loans

While DSCR loans are an excellent option for commercial real estate investors, they also have their drawbacks. They generally require a bigger down payment than traditional loan products, which can be a barrier for some borrowers. Potential borrowers should note that owning a property may carry additional unforeseen expenses than renting. Thus, your cash flow might not align with your investment’s profit generation in the short term.

Another disadvantage of DSCR loans is they usually come with a higher interest rate. Having said that, DSCR loans can be refinanced down the road if interest rates drop.

Finally, DSCR loans cannot be used for primary residences.

Conclusion:

Overall, DSCR loans are a valuable option for those looking to invest in real estate. They offer borrowers with lower credit scores or patchy income documentation more flexibility than traditional loans, and the underwriting process is generally much easier.

The key to DSCR loans is the ratio. For any potential property, it’s good to go ahead and do the math to ensure the rental income will be sufficient to cover the expenses. Use a 1.2 ratio as a rule of thumb. You can find tools online to help you with this calculation, including AirDNA and Bigger Pockets.

It’s essential to weigh the pros and cons of DSCR loans versus traditional loans before deciding which option is the best for your investment. If you have a sound investment strategy that holds the potential to produce regular income streams, DSCR loans can be an excellent way to acquire the funds you need to purchase properties.