Many landlords are finding it difficult to finance or refinance their properties thanks to high interest rates and high debt-to-income ratios. Debt Service Coverage Ratio (DSCR) loans are an option that prioritizes cash flow on the property over the landlord’s personal credit. While DSCR loans appear to be the solution to many investors’ prayers, there are many downsides to DSCR loans. I have looked into the loans many times but have never personally pulled the trigger on one.
What is a DSCR Loan?
Unlike traditional loans that rely heavily on your personal income and credit score, DSCR loans focus on the income-generating potential of the property itself. These loans are particularly ideal for investors with:
- Limited traditional income: Self-employed individuals, business owners, or those with irregular earnings can qualify based on the property’s projected rental income.
- Multiple mortgaged properties: If you already have several investment properties, traditional lenders might not give any additional loans. There could be portfolio lenders who will lend to investors, usually small banks and DSCR lenders who do not care how many properties you have.
How Does a DSCR Loan Work?
Instead of scrutinizing your tax returns and credit score, DSCR loans use a simple formula:
DSCR = Net Operating Income (NOI) / Total Debt Service (TDS)
- NOI: Rental income minus operating expenses like property taxes, insurance, and maintenance.
- TDS: Monthly principal and interest payments on the loan.
A minimum DSCR ratio, typically between 1.25 and 1.5, is required for loan approval (some lenders may go down to 1.0 with a large down payment). This ensures the property generates enough income to comfortably cover its debt obligations.
Some DSCR lenders will also lend on potential cash flow which means the property does not have to be fully stabilized before they will consider it. It is also important to know what the lender’s definition of cash flow is because my definition is much different than theirs!
Pros and cons of DSCR loans
Advantages of DSCR Loans:
- Access to financing: Even with imperfect credit or limited income, you can secure funding for promising investment opportunities.
- Focus on cash flow: The emphasis on property income encourages responsible investment choices based on sustainable potential.
- Faster closing times: DSCR loan applications can be less complex and quicker to process compared to traditional loans.
Risks and Considerations:
- Higher interest rates: DSCR loans often come with higher interest rates than traditional loans due to the perceived increased risk.
- Stricter property requirements: Lenders might have specific criteria for property type, location, and rental income potential.
- Limited loan-to-value (LTV) ratios: The amount you can borrow might be lower compared to traditional loans, requiring a larger down payment.
- Pre-payment penalties: Most DSCR loans come with large pre-payment penalties which means you will need to hold that loan for the long term or pay hefty penalties.
Is a DSCR Loan Right for You?
While DSCR loans offer enticing possibilities, careful evaluation is crucial. Consider these factors:
- Your financial goals: Is the higher potential return worth the increased interest costs and risk?
- Property selection: Can you find a property with strong enough rental income to meet the DSCR requirements?
- Exit strategy: Are you prepared to hold the property long enough to avoid the pre-payment penalties or are you willing to pay them if you need to sell or refinance?
Why Have I not used a DSCR loan?
I have looked into using DSCR loans on some of my properties but there are a few reasons I have never pulled the trigger.
- The pre-payment penalty is a huge downside right now when interest rates are dropping and I may want to refinance in a year or two.
- The interest rates always seem to be quite a bit higher when I get my official quote than what is originally advertised.
- There are quite a bit of origination fees and points when using a broker.
- Many DSCR lenders will not lend on mixed-use or commercial properties which I have a lot of!
If you can get local bank financing it is usually much better than a DSCR lender. The rates are lower with no pre-payment penalties but the banks may have shorter terms on their loans as well. I may look into DSCR loans again and you can find some lending options on my resources page if you are looking for a lender.
Below is the property I may be looking to refinance soon.
Build a Rental Property Empire
Source: investfourmore.com