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In recent years, a fairly new loan product: Debt Service Coverage Ratio (DSCR) loans, has become enormously popular with real estate investors. DSCR loans have become a critical tool for investors on track to achieve their dreams of financial freedom.
These loans, meant specifically for investment properties only, are so effective and popular because they require no income verification (or Debt-To-Income Ratio) and no tax returns or endless paperwork. Further — while the qualification and documentation are much less than conventional mortgages — the interest rates are just barely higher (typically less than 1% more). These loans offer fixed rates for 30 years, including options where it’s interest-only for the first 10 years, so you avoid the payoff and refinance pressure that often comes with hard money alternatives.
Put together, it’s no wonder why investors have flocked to these loans to scale their portfolios and achieve their dreams of financial freedom.
How Do You Qualify For a DSCR Loan?
Potential borrowers can sometimes encounter confusion when first learning about DSCR loans. Specifically, the qualification process, especially if they have been in the wringer with a conventional qualification. While conventional lenders will scrutinize seemingly every aspect of your income, expenses, bank account transactions, and credit history — DSCR loans are different, as the qualification and underwriting are primarily focused on the property instead of you, the borrower.
DSCR lenders will look at your credit score and make sure you have a few months of payments in the bank, but other than that, your property qualifies, not you! That means your income sources, whether you have a W-2 job, own a business, invest in real estate full time, or are retired or between jobs, don’t matter! DSCR lenders strictly do not take income into account!
What Determines My Rate and Terms?
So what does determine if you qualify and what rate you will pay? It primarily comes from three key factors:
- DSCR (Debt-Service-Coverage-Ratio)
- LTV (Loan-To-Value Ratio)
- FICO (Credit Score)
Debt Service Coverage Ratio (DSCR)
It’s no surprise that the DSCR metric is important for DSCR loans. The Debt Service Coverage Ratio measures the income from the property (rents) divided by the main expenses (principal and interest on your mortgage loan, plus property taxes, insurance, and any applicable HOA dues).
Real estate investors generally invest for monthly cash flow from their rental properties, which is achieved when income exceeds their expenses and they have profit left over. A DSCR of 1.00x means that income equals expenses, and the investor is breaking even. A DSCR above 1.00x means the investor is making money as they now have cash flow. For example, a DSCR of 1.25x would occur if the property earns $1,250 per month in rent and has $1,000 in PITIA (expense – principal + interest + taxes + insurance + association dues). A DSCR below 1.00x means that expenses exceed income, so the investor is losing money every month.
How does this work from the lender’s perspective? A lender will generally want the investor to make the most cash flow possible because the primary concern is the ability to make payments on the mortgage loan. Therefore, the higher the DSCR, the better lending terms an investor will get because the lender can be more confident of getting paid back as the rent more than covers the debt payments each month!
Loan-To-Value Ratio (LTV)
The second determining factor is the loan-to-value ratio (LTV). This is a simple metric comparing your loan amount to the value of the property. This is extremely important for the lender because the lender’s main recourse if you stop paying (default) on the loan is to foreclose on the property and replace the money lost on the unpaid debt with the real estate asset. Simply, if the lender can sell the property for more than what is owed in a foreclosure situation, then the lender is protected from losing any money.
As such, the lower the LTV, the lower the risk of loss for the lender, as they have a larger “cushion” in case foreclosure is needed. For example, in an 80% LTV scenario (say, a borrower purchases a property and puts 20% down), a $1,000,000 property would carry an $800,000 loan with a $200,000 “cushion” or equity for the borrower. In this situation, if the borrower defaults and the lender needs to foreclose, as long as the property hasn’t declined in value by more than 20% ($200,000), the lender is protected against the risk of loss, since they would then own a property worth more than the canceled debt.
In this example, if the property maintained this value of $1,000,000 and the lender foreclosed due to default, the lender actually comes out ahead, owning a $1,000,000 property instead of an $800,000 note. However, in the real world, it’s not so simple (as all real estate investors know very well!), as there are closing costs, legal fees, and time and energy spent in this process that nearly all lenders would prefer to avoid.
So how does this affect borrowing terms? Simply, the lower the LTV, the better the terms for the borrower, as it increases the “cushion” for the lender in the case of declining value and foreclosure. In the above example, the value of the property would have had to decrease by more than 20% for the lender to lose money, an unlikely but plausible scenario. However, if the LTV had been 60%, i.e., a $600,000 loan on a $1,000,000 property, the value would have had to decrease by a whopping 40% or $400,000 for the lender to be in a loss position. Much more unlikely! Thus, the lender can offer better terms (like a lower rate) on the 60% LTV loan as it carries much less risk.
FICO (Credit Score)
The final key metric towards qualifying for a DSCR loan is your FICO or qualifying credit score. Typically, there are three credit scores for everyone, Equifax, Experian, and TransUnion, and the score used for qualifying for the loan will be the middle one.
While DSCR loans are primarily based on the property rather than the individual borrower, the lender is still looking at credit scores as part of the big picture of qualification. Note that the credit scores from a mortgage lender will be calculated a little differently than the score you may see from a normal bank or online data provider. These scores are weighted a bit more heavily towards real estate credit, taking things like other mortgage debt more into account.
From the lender’s perspective, someone with a long and great history of timely and full payments on other mortgages is a great indicator of the likelihood of perfect and timely payments on your DSCR loan. So the better the credit, the better the terms.
Other Factors That Determine Qualification
While the “big three” metrics listed above are the main determinants for your qualification and rate — other factors make a difference as well, albeit not quite as important. Some other factors that DSCR lenders utilize include:
- Loan Purpose: Typically, you will get better terms on an acquisition than a cash-out refinance, as the value utilized by the lender is more certain on a purchase, and there’s more guaranteed “skin in the game” for the borrower.
- Loan Size: DSCR lenders typically like a “Goldilocks sweet spot” loan size, not too big and not too small for the best pricing. This is because there’s less of a market for supersized rental properties (i.e., how many potential buyers or renters are there for $3M+ mansions), but conversely, a too-small value property (worth $200k or less) may indicate a declining or ultra-rural market, a rough neighborhood or a property in poor condition. The best rates and lowest fees typically come in the $250k – $750k loan amount range.
- Prepayment Penalties: DSCR lenders are known for giving the best rates when penalties for prepaying the loan (i.e., a fee if you prepay early in the term) are higher. If you are a long-time-horizon investor and don’t plan on selling quickly, it’s often a good idea to trade prepay penalties within the first five years for a much lower rate.
How To Pick a DSCR Lender
Once you are ready to take out a DSCR loan — it’s time to pick the lender that’s right for you. It can sometimes be overwhelming to figure out how to start and who to pick. There are lots of DSCR lenders out there offering the product.
Here’s the secret about DSCR loans that not a lot of lenders will tell you: the loan product is mostly the same among all the lenders. While there are some differences along the edges and with exact interest rates, most of the time, the loans are more or less the same. And when it comes to rates, one lender may have the best rates at a given time, but as in all competitive markets, it won’t last for long, and rates will eventually converge to essentially the same.
So how do you pick the right DSCR lender, not just for your immediate deal, but for establishing a long-term relationship?
You are going to want to hone in on the true specialties and differences in loan programs offered and the reputation and financial strength of the lender as well. Rates and fees are likely to end up being pretty similar, so make sure to ask good questions and find out why they are different.
Some suggested questions to get you started:
- Are you a direct lender who lends your own capital or a brokerage intermediary that works with other lenders?
- Do you have any special programs for property types, such as short and medium-term rental financing? Any BRRRR lending programs?
- What is the maximum LTV you lend to?
- Do you require a DSCR to be at least 1.00x, or do you have options for non-cash-flowing properties?
- When there are partners (i.e., 50/50 owners of an LLC) borrowing on a DSCR loan, do you qualify the FICO score of the higher or lower partner?
Choosing a DSCR lender and then ensuring your qualification gives you the lowest possible rates and fees can be an overwhelming experience. Hopefully, this article can serve as a strong resource in helping you select the best DSCR loan for your investing journey.
This article is presented by Easy Street Capital
Easy Street Capital is a private real estate lender headquartered in Austin, Texas, serving real estate investors around the country. Defined by an experienced team and innovative loan programs, Easy Street Capital is the ideal financing partner for real estate investors of all experience levels and specialties. Whether an investor is fixing and flipping, financing a cash-flowing rental, or building ground-up, we have a solution to fit those needs.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.