How to Get a DSCR Loan + DSCR Calculation
If you want to use rental income to help finance an investment property, a debt service coverage ratio (DSCR) mortgage could meet your requirements. The cash flow from the property can be used to qualify for the loan without needing to provide additional income documentation, such as tax returns.
But is a DSCR loan right for you? We take a look at what a DSCR loan offers and how it works.
How Do DSCR Loans Work
When applying for a DSCR mortgage, the rental income has to at least meet the coverage ratio required by the lender. Lenders require (usually) the DSCR to be 1.0 or more, though it can still be possible to buy when the DSCR is 0.75.
As an example, a 0.85 coverage ratio means that the rental payments aren’t enough to cover the mortgage, and the missing 15% has to be covered by the borrower. In these cases, the lender will likely want to see strong reserves so that they know the loan payments can be covered by the borrower.
Since the qualification for this loan is based on the cash flow the home produces, you will not need to prove income or worry about your debt-to-income ratio, though your credit score can still be important.
If you don’t have the level of income required to qualify for a standard investment property mortgage, this loan still allows you to buy a rental. If you have or don’t want to provide employment, tax, or other financial documents, this mortgage program still helps you buy or refinance investment properties.
It isn’t all good news, however, as the mortgage rate is likely to be higher, and you will need a down payment of 20% or more.
The most important factor with this type of loan is the coverage ratio. The debt service coverage ratio is calculated using rental income compared to the monthly mortgage payments. This can be based on the rent schedule from the appraisal report if there isn’t a signed lease agreement.
If the property is a single family home, the rent schedule used is a 1007 form. For properties with up to four units, a small residential income property appraisal 1025 form might be required.
Calculate Your DSCR
Your DSCR is calculated by taking the gross rental income of the property as per the existing lease agreement or rent schedule and dividing it by the loan payment (PITIA)
The DSCR formula for calculating is:
DSCR = Gross Rental Income ÷ Mortgage Payment (PITIA)
For example, if the property generates $6,000 in rent each month, and mortgage payments are also $6,000 a month, the DSCR will be 1.0. But if the mortgage payments are $4,000 per month, the DSCR will be 1.5, a more comfortable figure for lenders and more likely to be approved.
If the rent is $6,000, but the payment is $7,000, the DSCR will be 0.8571. This means the borrower would additionally have to pay $1,000 per month.
Why is Debt Service Coverage Ratio Important?
Lenders use and place importance on this figure as it indicates the amount of risk involved in the loan application. The lender wants to ensure the borrower will pay back the money they are loaning to them.
If you have a higher DSCR, you might benefit from better terms from a lender. With lower risk, the lender could offer better interest rates or other benefits.
What Do Lenders Consider a Good DSCR Ratio?
While lenders like to see a DSCR ratio of 1.00, if the DSCR is only just above that number, it doesn’t leave much room to deal with reductions in operating income. If the DSCR drops it risks the borrower defaulting on the loan. For this reason, typically lenders prefer to see a DSCR of at least 1.2 to 1.25. The lender might also require a certain DSCR to be maintained during the loan.
DSCR Loan Requirements
As well as the coverage ratio, there are other important requirements to consider when applying for this type of loan:
Typical maximum LTV ratios are 80%, meaning you will need a down payment of 20%.
Some lenders might approve loans as high as $2 million in some situations. This loan amount is higher than the maximum often allowed with standard investment loan programs.
Types of Loans
Lenders typically allow adjustable rate (ARM) as well as fixed rate and interest-only home loans. 40-year interest-only loan terms are offered by some lenders.
A DSCR loan is more likely to include prepayment penalties compared to a standard investment property loan. Before you choose a DSCR loan, make sure you know what penalties will be due if you decide to refinance.
With a DSCR loan, the lender often allows homes to be financed that aren’t covered by standard investment home loans. Non-warrantable condos that don’t meet conventional guidelines for government-backed programs, and properties containing more than four units can be financed.
If you are looking to build your property portfolio, many lenders don’t limit the number of rentals you can finance with DSCR loans.
If you want to refinance, rate-and-term and cash-out options are offered by most programs. This might allow you to cash out more from your investment property with a DSCR loan compared to other options.
If your credit score is low, it might not be as difficult to qualify for this type of loan compared to other options. Most lenders will require a credit score of 660 or higher.
With a DSCR loan, lenders don’t check your income when you apply. This means they don’t check your debt-to-income ratio either. With this type of loan, there are fewer checks required overall for the borrower to be approved.
Costs and Fees
The interest rates charged on a DSCR loan are higher than other types of investment loans.
Costs to close using a DSCR loan are similar to standard investment property loans and vary depending on the lender. The fees charged by the lender will differ and need to be considered when comparing your options.
Apply for a DSCR Loan
When you apply for a DSCR loan, the lender should clearly lay out the terms of the loan, including the fees, interest rate, loan amount, and more. They will calculate the DSCR and ensure that your application meets their underwriting requirements.
Standard loan documentation will have to be filled out, but you won’t be required to provide information about your personal income.
Without a requirement to provide income, the closing can sometimes take place sooner compared to other loans.
Is it Easy to Qualify for a DSCR Loan?
In general, it is easier to get approved for a DSCR loan compared to other home loans. Since the income the property generates is usually the most important deciding factor for the lender, approval can be easier.
The lender doesn’t need to check income or your debt-to-income ratio, which speeds up the process. This makes the process of applying for a DSCR loan more streamlined, with fewer requirements to concern borrowers.
Pros and Cons of DSCR Mortgages
Before you decide that this type of loan product is right for your situation, you need to weigh the positives and negatives.
Benefits of a DSCR Loan
Your income doesn’t matter to the lender
If you have cash but not a reliable source of income, a DSCR loan might be a good option. You might have the money for larger down payments, but without proof of income, most mortgages could be out of your reach.
It allows you to buy multiple properties
If you are a real estate investor and you want to build a portfolio of rentals, you can take out multiple DSCR loans at the same time. Other types of investment mortgages might require that you only pay the home loan on one property at a time.
Without the need to provide personal financial information that needs to be checked during underwriting, the loan application can be processed faster.
Allows you to buy different types of properties
Sometimes homes that don’t meet the government-backed requirements of Fannie Mae and Freddie Mac can be purchased with this type of loan. You might be able to use this loan to buy multi-family properties, hotels, and office space. Non-warrantable condos and vacation rentals by owner properties are often allowed.
Cons of a Debt-Service Coverage Ratio Mortgage Loan
Larger down payments
You will need a 20% down payment as a minimum with this type of loan. In some circumstances, like a lower DSCR, the lender might require 30% down.
Higher interest rates
You can expect to pay more in interest on a DSCR loan than on a regular conventional loan.
Final Thoughts on the DSCR Loan Program
If you want to create a rental property business, but don’t have the income necessary to be approved for a standard loan, DSCR loans are a great option. You might already have rentals that are profitable or have cash flow and want to expand, but if you can’t meet the lender’s income requirements, DSCR loans are typically worth considering.
If you can qualify for other investment loans, you might find they offer more competitive interest rates, however. But often they won’t allow you to buy multiple properties at the same time, so a DSCR could still be a better option.