If you’re a real estate investor, you know how difficult it can be to secure a loan for your next project. Traditional lenders look at your personal income to determine your eligibility. However, if you’re an investor, you take deductions on your tax returns to reduce your taxable (net) income, potentially affecting your ability to obtain a mortgage loan.
DSCR loans are designed to help new and veteran real estate investors purchase property and expand their portfolios. Unlike traditional loans, DSCR loans don’t require proof of income. Instead, borrowers can qualify based on the property’s cash flow, offering faster closing times and more flexible funding solutions.
But what is a DSCR loan, and is it the right option for your next venture? DSCR loans make qualifying based on rental income easier, allowing you to start earning from your investments faster. Keep reading to learn more about DSCR loan pros and cons to determine if it’s the right option for your next investment.
What Is the Debt Service Coverage Ratio?
Debt service coverage ratio (DSCR) is a metric that lenders use to determine your ability to repay the loan. Real estate investors typically have lower net incomes after deducting expenses on their taxes, which can affect their chances of getting approved for a conventional loan. As a result, the adjusted income ends up being much lower, and many lenders have strict requirements that prevent them from being able to lend to these types of borrowers.
However, DSCR loans make it easy for borrowers to qualify for an investment property loan based on their cash flow (rental income) instead of personal income or job history. You can calculate DSCR by dividing the gross rental income by the debt service, resulting in a decimal that can tell you whether or not a property has a high enough income to repay the loan.
How Do DSCR Loans Work?
DSCR loans are designed for investors only, not for purchasing a primary residence. Instead, you can use them to purchase or repair short and long-term rental properties, including homes, apartments, condos, and townhomes.
Again, your DSCR tells lenders whether you can repay the loan using rental income. A DSCR of 1 tells lenders that the property has exactly enough income to repay the loan. However, this isn’t ideal because you have other obligations, such as expenses like employees, repairs, maintenance, etc. Therefore, most lenders like to see a higher DSCR of at least 1.25 to prove your ability to repay and allow for extra cash flow for expenses that won’t get in the way of repaying your debt.
A higher DSCR makes you more appealing to lenders, allowing you to qualify for higher loan amounts. However, the DSCR required for a loan varies by lender, with most requiring a DSCR of at least 1.25. However, Griffin Funding offers more flexibility than other lenders and allows you to qualify with a DSCR as low as 0.75, and below 0.75 with a higher downpayment on an exception only basis. Still, we recommend increasing your ratio as much as possible to reduce your interest rate and ensure you can get the necessary loan amount.
Of course, even though lenders don’t review your personal income, they’ll need to review documentation for the property to determine whether it can generate enough cash flow to meet the DSCR requirement. To apply for these loans, you’ll need to provide a signed lease agreement to view current rental income or an appraisal of the property. Unfortunately, not having a signed lease agreement that details the current rent can affect your interest rates since providing a loan based on the appraisal alone is riskier for the lender.
Advantages of DSCR Loans
DSCR loans are often easier to qualify for and offer a streamlined approval process because there’s no personal income or job history requirement. Advantages of DSCR loans include the following:
Accessibility: Your eligibility for a DSCR loan is determined by a single figure: your DSCR. Since lenders don’t consider personal finances, they’re more accessible to all types of borrowers, including novice and veteran investors.
Streamlined approval process: DSCR loans typically have a streamlined application and approval process, offering faster closing times than other types of investment loans. Since you don’t have to submit personal financial information, the application and underwriting process is straightforward, and approvals are typically much faster.
Unlimited cash-out: DSCR loans offer unlimited cash-out, which means you can continue taking out money when needed to cover expenses like repairs.
No limit on the number of properties: DSCR loans allow investors to purchase multiple properties simultaneously. With traditional loans, borrowers can’t purchase another property until they’ve paid off their existing debt. However, with DSCR loans, investors can purchase as many properties as they want to build their portfolios.
All types of rentals eligible: DSCR loans can be used for all types of rentals, including short and long-term rentals and various properties, including single and multi-family homes. Additionally, you can use a DSCR loan for LLCs to purchase commercial properties for business purpose use.
Jumbo DSCR Loans: Jumbo DSCR loans are ideal for real estate investors who focus on investing in high-end luxury properties.
Risks of DSCR Loans
Unfortunately, like all types of loans, DSCR loans have pros and cons that may make you reconsider whether this option is right for you. The cons of DSCR loans include the following:
Large down payments: Most lenders require a large down payment of at least 20%, which may be higher than some conventional mortgages.
Higher interest rates: DSCR rates are typically higher because these loans are riskier investments for the lender. Additionally, the lender can require you to pay higher service fees; the higher your loan amount, the more those will cost.
Limited financing: DSCR loans offer amounts from $100,000 minimum to $5,000,000 maximum. If you’re purchasing multiple properties or an expensive property in an expensive market, these loans might not be right for you.
For rentals only: DSCR loans are for rental properties only; they can’t be used for a primary residence or to fix and flip a home. Instead, you can only use a DSCR loan for a property that generates cash flow. If you plan to flip a home, you’ll need another type of mortgage loan.
Vacancies: It’s normal for rental properties to have vacancies every now and then. However, you’re not generating any cash flow if you have vacancies. Lenders don’t assess your ability to repay your mortgage if your property or units within the property are vacant, so you could end up getting deeper into debt if you’re not consistently generating cash flow.
Pre-Payment Penalties: Most DSCR loans come with a pre-payment penalty ranging anywhere from 1-5 years. You will get a lower interest rate in most cases if you opt for a prepayment penalty, however, there are many different kinds of pre-payment penalties so make sure to discuss the details with your loan officer of all your options.
Is a DSCR Loan Right for Me?
After reading the DSCR pros and cons above, you might wonder whether this type of loan can help you fund your next real estate project. Remember, these types of loans are only available for rental properties used for business purposes; they can’t be used for primary residences.
A DSCR is a good option for both novice and veteran real estate investors because it allows them to qualify based on rental income instead of personal income. If you’re new to real estate investing, a DSCR loan can help you get the financing you need for your first property, and if you’re a seasoned investor, it can help you get faster financing to help you grow your portfolio.
However, no financing option is perfect. Since DSCR loans come with higher down payment requirements and interest rates, they’re not the ideal financing option for every investor.
Alternatives to DSCR loans
Learning DSCR loan pros and cons can help you determine whether DSCR loans are the right financing for your real estate investment. However, if you decide a DSCR loan isn’t right for you or don’t qualify, you still have options. Griffin Funding offers a range of mortgage options for investors to help you build your portfolio. A few alternatives to DSCR loans include the following:
Bank statement loans: Bank statement loans allow you to qualify for a real estate loan using alternative underwriting methods. Instead of sending us your pay stubs and W2s, we’ll review your bank statements to determine your eligibility.
Asset-based loans: Asset-based loans allow you to qualify for a mortgage by converting your assets into income instead of using them as collateral. With asset-based loans, you can qualify using bank, investment, and retirement accounts.
Jumbo loans: Jumbo loans are ideal for investors who need a higher loan amount with a more flexible down payment and DTI requirements. These loans are best suited for high-income earners.
Commercial real estate loans: Commercial real estate loans are tailored for each borrower to help you expand your portfolio with single-family homes, multi-family homes, condos, townhomes, and commercial property.