An In-Depth Look at the “DSCR” Loan for Residential Investment Properties

Last week I promised to talk about the 3 types of mortgages that business people and property investors use. This week we’re going to take an in-depth look at one of these loans: the DSCR loan.

To make this abundantly clear, the DSCR loan and the other two types of loans that business people and property investors like to use are advanced mortgage products outside of Fannie Mae & Freddie Mac. 

Fannie Mae & Freddie Mac type mortgages are government subsidized loans that were born during the 1930s depression and around World War II to promote home ownership. These loans are what you see advertised on the media and online. These are the loans that dominate most mortgage companies.

However, Fannie Mae & Freddie Mac loans are an exception! They are a specialized type of financing that has strict rules, depends on tax returns to prove income and are best suited for W2 employees. 

Fannie Mae & Freddie Mac loans do have an investment option for rental properties, and if you meet their strict guidelines, then you might get a competitive mortgage for your investment property. 

Most investors and business people however, would prefer the DSRC Loan. 

DSCR is an acronym used in Commercial Investment Property Financing and it means:

"Debt Service Coverage Ratio"

I am going to explain what this means: 

For any loan, the most important component is INCOME! This determines whether or not you can afford the payments on the loan.

When you buy a home, either to live in it or for investment purposes through a Fannie Mae or Freddie Mac loan, your personal or business income has to be sufficient to make all your payment obligations plus the new property you are buying. 

However in the Commercial World, it is not your income that the lender wants to see. The lender is going to analyze the property's income to make sure the mortgage can be paid. 

In a nutshell, the lender is going to take all the income from a building, deduct all the expenses and then see if the result of this calculation is at least 1.25 times more than the mortgage payment.

The net income a building produces, meaning all income minus expenses, is called the "Net Operating Income" and is abbreviated as NOI.

Example: Say a building has a Net Operating Income of $5,000 per month and the mortgage payment is $4,000 per month.

The lender performs this calculation:

5,000 / 4,000 = 1.25

This means, that the Net Operating Income is 1.25 times more than the mortgage.

This ratio of 1.25 times has a really fancy name:

Debt Service Coverage Ratio, abbreviated as DSCR.

"Debt Service" means paying the mortgage’s monthly payments, "Coverage" in this sense means "how much to cover" and "Ratio", because the 1.25 number is a ratio that compares NOI to a mortgage payment. 

The 1.25 is not a percentage but the number of times that monthly income is greater than the monthly mortgage payment. 

This number, or “ratio,” changes from lender to lender and between different loan programs.

When the economy is fragile or volatile, lenders tend to increase the ratio above 1.25, for example, 1.3 or 1.4, to make sure there is more income relative to the loan payment.

In the Commercial World (buildings consisting of 5 or more dwelling units), this number would never be under 1.2.

However in the Residential World, meaning a property that has 4 or less dwellings, this number can be as low as 0.75!

This means that for a regular home, duplex, triplex or fourplex, the lender would allow you to borrow even if the Net Operating Income of the property is BELOW the mortgage payment!

We specialize in mortgage programs that have a ratio of at least 1. Meaning that the NOI of the property must at least match the mortgage payment plus property taxes and insurance. This is the bare break-even point of a property.

This would never be allowed on a commercial property where the NOI always has to be higher than the mortgage payment!

But it gets better.

In the Commercial World (5 units and above), to calculate the Net Operating Income, you must deduct not only the Property Taxes and Property Insurance but also: a percentage of the income to set aside for property maintenance, management, a vacancy allocation even if the property is fully rented, and more!

The DSCR Mortgage Program we specialize in, which covers residential properties (up to 4 dwellings in one building), only requires you to deduct Property Taxes & Insurance to get to the Net Operating Income or NOI.

Example: 

Property Income:              $5,000

Property Taxes:                ($1,250)

Property Insurance:          ($300)

Net Operating Income:       $3,450

So in this example, you have an income of $3,450 available to pay the mortgage.

If we applied the Commercial Standards to this property and had to deduct an allocation for maintenance, vacancies, management (even if you do this yourself) and other costs, the result could be zero or negative. 

So instead of having to show tax returns or proof that you have $3,450/m to pay the mortgage, the property's income proves it for you.  

This saves an enormous amount of time, headache and paperwork! In practice I have found that it saves at least 2 weeks of the mortgage process, and this is why these mortgages can be done in a relatively short amount of time.

But it gets even better.

What if the property is vacant?

Then the lender will ask an appraiser to estimate the rental income in the area where the property is located and come up with estimates.

These estimates from the appraiser will qualify you, EVEN if the property is VACANT. The only caveat is that you will need to get the property rented within 60 days of the loan closing.

So to recap: 

A Debt Service Coverage Ratio Loan or DSCR Loan allows you to use either the existing income of the property or the potential income of the property to satisfy the lender's income requirement. 

Income is 90% of the loan! 

This allows you to purchase or refinance a property using only the actual income or potential income of the property rather than you having to prove to the lender that you are personally able to afford the mortgage.

This is a very powerful tool for investors.

To utilize this tool—in general, for a purchase you would need a downpayment of 30% and a credit score of 680 or more, and for a refinance you would also need a minimum of a 30% equity cushion. 

As a comparison, if you wanted to use the Fannie Mae or Freddy Mac mortgages for investment properties, you would still need at least 25% down to make these loans work, and you would need to demonstrate that YOU have enough income to afford them. You would prove your income using tax returns, which could be a very laborious process. 

The DSCR loan has another "icing on the cake" for investors. Most mortgage companies place a limit on how many properties you can finance. This limit has fluctuated between 4 to 10 over the years.

With the DSCR loan, since by definition it is a business/investment loan, you can close the loan under a corporate entity, and it does not even go on your credit. This means that you can have as many DSCR loans as you wish.

In summary, for a property investor, the DSCR loan brings the flexibility of a Commercial World loan into the field of Residential Investment Properties! 

Last but not least, I am happy to be able to say that we offer the best rates for these types of loans. That is because I diligently do my research, and I work with lenders that specialize in this type of product. 

There is more to a DSCR loan, but there is only so much I can say in one article.

If you would like to see how such a scenario could play out for you, contact us and I will let you know the ins and outs of how this would work in your exact situation at no cost to you. Feel free to self-schedule an appointment here.