Debt Service Coverage Ratio (DSCR) loans are crucial in the world of real estate investing.
Rather than focusing on a borrower’s personal income, DSCR lenders are more concerned about the property’s income (and income potential).
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This key characteristic of the loan unlocks opportunities for investors that they may not be able to access otherwise.
Let’s take a close look at how DSCR loans work and how investors can qualify.
How do DSCR loans work?
Real estate investors frequently have difficulty proving their true income to lenders with W2s, tax returns or pay stubs.
As a result, it can be more difficult to qualify for a loan based on these factors alone.
DSCR loan qualification relies instead on your property’s cash flow. The formula for calculating this ratio is as follows:
DSCR = Net Operating Income / Debt Obligation
Your net operating income—NOI—is your property’s income after operating expenses. Your debt obligations include your principal, interest, taxes, insurance and other debt-related expenses.
Some lenders calculate DSCR on a monthly basis to evaluate whether the property generates sufficient income each month to cover the monthly debt obligations, while others may calculate DSCR on an annual basis.
Here is an example of DSCR calculated on a monthly basis: If your monthly expected NOI for a property is $5,000 and your monthly debts are $3,500, your DSCR is 1.4.
Generally, lenders look for a DSCR that is 1.0 or higher.
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Who are DSCR loans for?
DSCR loans are ideal for borrowers who require flexibility with income documentation, including:
- Real estate investors
- Business owners
- Those who have trouble proving their income on tax returns
Both new investors and seasoned investors can benefit from a DSCR loan.
Many DSCR lenders will allow you to use this loan on your first property, as long as you bring a solid deal to the table.
How do DSCR loans differ from traditional mortgages?
DSCR loans and conventional loans are equally viable for purchasing investment properties. How do you know which option is right for you?
The major benefit of a DSCR loan is that borrowers don’t have to provide income documentation.
Conventional loans require proof of income via W2s, pay stubs, tax returns and other documentation. Many investors and business owners cannot easily meet this requirement.
Beyond this major benefit, the preferability of either a DSCR loan or a conventional loan depends on your unique needs as an investor or business owner.
If you need more flexible requirements for your personal finances, property types, loan amounts and the amount of properties you own, a DSCR loan is the ideal option.
How to qualify for a DSCR loan
The exact requirements for a DSCR loan vary by lender, property type and other factors; but generally, you can expect the following:
- DSCR of 1.0 or higher
- Income-generating properties only
- Loan amounts up to $5 million
- Single-family and multifamily properties
- Commercial properties
- Long-term and short-term rentals
- Property appraisal
- Credit score of 620 or higher
- A down payment of 20-25%
- Borrowers can close as individuals, LLCs, corporations or other entities
Your lender will not need to see W2s, 1099s or pay stubs, and they won’t calculate your debt-to-income ratio (DTI).
Lenders often offer both fixed-rate and adjustable-rate DSCR loans, with terms of up to 30 years.
What your DSCR lender wants to see
DSCR lenders generally look for the following key elements from borrowers.
Projected property income and debt service
Your lender will request a 1007 rent schedule from a licensed (or certified) appraiser to determine the fair market rent for the property.
You will also need to provide the amount of taxes, insurance, homeowners association dues and other debt service figures to allow the lender to calculate your DSCR.
Strong DSCR ratio
Above all else, your lender needs proof that your property’s income can cover the principal, interest, taxes and insurance.
Many lenders will accept a DSCR of 1.0, which means the property’s income amount and debt service are the same.
Others require a DSCR of 1.25 or higher to prove that you can comfortably meet your financial obligations.
If your DSCR is too low, you can try increasing your NOI or lowering your operating expenses.
Your investment experience
DSCR lenders are interested in a borrower’s previous experiences with property management and real estate investing.
While your experience can help you qualify, this doesn’t mean that new investors are out of luck.
Work closely with your lender to make sure you understand the requirements and are able to successfully fulfill them. DSCR loans rely more on a strong ratio than any other factor.
While personal income documentation may not be a primary factor in DSCR loan underwriting, lenders may still evaluate the borrower’s creditworthiness and financial stability to some extent.
Most lenders would like to see borrowers with a credit score of at least 620 demonstrate financial responsibility and the ability to manage debt.
Good property condition
The property’s condition can affect its potential to generate income and attract tenants.
Your lender will want to confirm the property’s condition and value with an appraisal.
Take the first step in getting your DSCR loan
To get a DSCR loan, borrowers must apply with a DSCR lender.
A strong working relationship with your DSCR lender is crucial to the success of the deal.
Compass Mortgage can help you navigate this complex loan with our simple, personalized process.
From there, our dedicated and experienced team can connect with you to gather the necessary documentation.
Still exploring your options? No problem. If you’re not sure if a DSCR loan is right for you and want to discuss the requirements in more detail, contact Compass Mortgage online or call us at (877) 667-0595.
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