A Non-QM (DSCR)

Debt Service Coverage Ratio (DSCR) Loan is categorized as a non-QM or a non-qualified mortgage. It is an option for people to buy a property for investment with a home loan. The best part is that the loan is not based on your income or tax returns but on the acquired property's projected cash flow potential.

Keep reading to learn more about the entire gamut of DSCR loans. 

Understanding the DSCR

Debt Service Coverage Ratio is a method for computing a rental property's cash flow. The computation method considers historical records of annual rents earned by the property owner and compares them to the property's PITI debt obligations. PITI stands for Principal, Interest, Taxes, and Insurance. HOA fees are also considered if applicable.

Lenders consider the DSCR one of the most important criteria when assessing whether to lend against an investment property. They use it to determine whether there will be adequate income from the property to support loan payments.

How do DSCR Loans Work?

If you want to get a loan on a rental property and do not want to undergo the verification processes of a conventional loan scenario, you can opt for a DSCR loan.

The advantage is that DSCR loans are more flexible than traditional loans, especially in terms of the choice of property and the number of properties you can purchase with a single loan.

DSCR lenders do not look at your personal debt-to-income ratio. Instead, they will inspect whether the property can generate income and cash flow to understand whether your debt obligations are secure. Thus, your finances do not determine whether you will get a DSCR loan.

The loan value usually ranges between $100,000 and $500,000 in the case of DSCR loans. Property investors often buy existing properties and offer rental prospects in the long run or on a short-term basis. This loan can be availed if you wish to convert a property into an investment option or renovate an existing property to earn rental income. You can also apply to construct a new property for rental purposes. 

Calculating DSCR

The Debt Service Coverage ratio is computed by dividing the annual net income from the rental property by the property's annual debt. In other words, 

DSCR = Annual Gross Rental Income / PITI

PITI stands for - 

P - Principle

I - Interest

T - Tax

I - Insurance

HOA/POA, if applicable, needs to be added.

• Calculating Annual Net Rental Income

Lenders consider two aspects to understand the property's annual net rental income. The first is the appraiser's comparable rent schedule. The second is the property's yearly rental income calculated from the signed lease agreement. Of these two, whichever is less is considered.

• Calculating Annual Debt 

All the respective PITI payments are used to calculate the annual debt. 

Getting a Loan: What is a Good DSCR

When the DSCR is more significant than 1.0, it indicates that the rental income is profitable, meaning the property owner can pay the debt. 

What do lenders look for? They typically look for a higher ratio. They want at least a 1.2 or 1.25 DSCR. This guarantees them that the applicant is in an excellent position to make the payments even in emergencies and unexpected events like a sudden repair, etc.

When the DSCR is 2.0 or more, there is a strong chance of getting a good loan; this is considered a great score. 

A higher debt service coverage ratio means a good chance of getting the loan on better terms.

DSCR Loan: Pros and Cons

What's Good about DSCR loans?

• It can be used to purchase investment properties.

• Your personal taxes or real estate write-offs do not affect DSCR.

• There is no requirement for your personal income, W-2, or 1099.

• It can be used to buy properties that are already generating rental income in the long or short term.

• The loan value is usually large. 

• No verification of your job or income is required.

• The closing time on the loan is faster.

• You can be a new or an existing investor, and anyone can avail of a DSCR loan.

• Unlimited cash-out

• A single or multiple loans can be taken for multiple properties.

• The loan can be closed as an LLC.

• This is an excellent option for building a solid real estate portfolio fast.

What is Not-so Good About DSCR Loans? 

• The down payment is much higher than a conventional loan.

• The interest rate is based on your credit score, and it must be higher than the minimum required for a conventional loan.

• It is mandatory to ensure the maintenance of minimum standards of the property even when cash flow is low.

• It cannot be your primary residence property. This loan is given only on investment properties in the long term.

• The fees and interest rates are comparatively higher.

• You may need to pay the debt using your personal income in case of a vacancy.

• Prepayment penalties may apply in particular loans.

Requirements for a DSCR Loan

The requirements usually differ from lender to lender. These will also depend on the property type you are purchasing. A few common requirements for these loans are - 

• The DSCR needs to meet the threshold or surpass the minimum score. Usually, a 1.2 ratio is usually considered okay, but your lender may have higher requirements.

• Lenders will also evaluate the property's rental history and its success in the short term and long term. The rental agreement and the active lease will illuminate these parameters.

• The lender might also appraise the property, especially if the rental history is unavailable. 

• Another consideration is the loan-to-value ratio (LTV). An LTV of 75% or more is considered suitable for the loan.

• Lenders will weigh your credit score to understand your creditworthiness. A score of 620 or more is the usual requirement. 

• The down payment for these loans is usually between 20% and 30% of the loan amount.

• Lenders might ask for your bank statements to understand your financial condition. 

• The property has to be insured so that lenders can recover their loan amount in case of damage or destruction. 

Ensure you understand every DSCR loan aspect before approaching a lender to finance your real estate investment.