Debt-Service Coverage Ratio (DSCR) Loans: What They Are and How They Work

Overview

Debt Service Coverage Ratio (DSCR) loans allow the borrower to qualify for a loan based solely on the cash flow generated from the investment property, not on their personal income. DSCR loans can be used to finance either residential or commercial properties.

Defining Debt Service Coverage Ratio (DSCR)

Before diving into the specifics of DSCR loans, it is important to understand what exactly DSCR is and why it is important.

Your debt service coverage ratio is defined as the “ratio” of cash available to “service” your debt.

In other words, it is a metric used to determine the amount of cash you have available to pay both the principal and the interest payments for your loan.

The ratio itself compares the target property’s net operating income (NOI) with the target mortgage debt service on an annualized basis (more on this below).

Your DSCR is important because it gives lenders valuable information about whether you (as the borrower) have access to enough cash flow to service your debt. A high enough DSCR provides some security to the lender that you’re unlikely to default on your loan payments.

How To Calculate Your DSCR

Calculate your DSCR by dividing the net operating income (NOI) of your property by the debt service of the loan (assessed on an annual basis).

Find your net operating income by subtracting all the reasonably necessary operating expenses of your property from the revenue that it generates.

The mathematical formula for calculating your DSCR = NOI ÷ DEBT SERVICE

Example of Calculating DSCR

Imagine you’re a developer who’s looking to get approved for a mortgage loan from your local bank.

Your bank lender will need to calculate your DSCR in order to determine your ability to borrow and pay off your loan while your rental property generates income.

You tell the bank lender that your NOI will be $2,000,000 per year. Your lender then notes that your debt service requirement will be $300,000 per year.

Based on those numbers, your DSCR will be about 6.67x.

That means you’ll be able to cover your debt service more than six times, given your operating income.

DSCR = 2,000,000 ÷ 300,000 =6.667

Why Does DSCR Matter?

Your Debt Service Coverage Ratio matters because it is a financial metric that provides lenders with important information about the risk they assume with each loan they make.

The DSCR signals to lenders whether a borrower will be able to pay their debts for a commercial or multifamily property.

A higher DSCR will also give you more leverage (i.e. bargaining power) with your lender.

What Is A “Good” DSCR?

Most business lenders require their borrowers to have a DSCR ratio higher than 1.00. In fact, the minimum for most lenders is typically around 1.25.

A DSCR ratio of 1.00 means that the cash flow generated from the property in question will be exactly enough to service the borrower’s loan.

A DSCR ratio of 1.25 means that the borrower will be able to service their loan, with some added cushion.

DSCR Loans: How They Work

Borrowers can use DSCR loans to finance multiple different property types, including:

  • Multifamily properties
  • Commercial office spaces
  • Hotels and resorts
  • Private mortgages

 

The minimum DSCR number that lenders will allow will depend on the macroeconomic conditions. In a growing economy, lenders might be more willing to offer DSCR loans despite a lower DSCR number.

To avoid exposure to property types they might deem risky, some lenders only offer DSCR loans for certain types of property.

The amount of money you can get through a DSCR loan depends on the lender. Most offer loans with limits up to 3-5M dollars.

How To Apply for A DSCR Loan

1. Underwriting

Your lender will outline all aspects of the loan, including the loan’s value, term, fees, and more. Your lender will also calculate your DSCR during this stage.

2. Documentation

DSCR loans will require you to fill out standard loan documentation.

Note that any financial documents you fill out for a DSCR loan will ask for information only about your business or rental property—not information that deals with your personal income history.

That’s because, by definition, lenders offer DSCR loans based solely on your Debt Service Coverage Ratio, not based on your personal financial history.

3. Submission and closing

Because they do not require information about your personal financial history, DSCR loans come with a much faster application and closing process than other types of loans.

Sample DSCR Loan Terms

Maximum Amount for Loan $4,000,000
DSCR Minimum 1.25
DSCR Calculation (yearly) DSCR =112 0006000 x 12 months = 1.56
Term 35 years
Amortization 35 years 
Interest Rates 3.9%
Additional Fees 20% upfront 

Lender Application fee – 0.2% loan

Closing fee – 0.5% loan 

Type of property  Multifamily (8 units)

Pros And Cons of DSCR Loans

Like every other financing tool, DSCR loans come with their own unique set of pros and cons.

Pros of DSCR Loans

1. Lenders don’t consider personal income

Because DSCR loans don’t consider your personal financial information, they’re much more accessible to borrowers who might not have large amounts of liquid capital.

2. They come with faster application and closing times

DSCR loans typically come with a streamlined, fast application process because you won’t need to submit any personal financial documents or explain gaps in work history.

3. You can commit to multiple properties at once

Some loans force you to commit to one property at a time. They don’t let you take out a loan for a second property unless you’ve paid off your first loan.

DSCR loans don’t operate like that. Instead, they allow you to take out multiple loans at once for different properties.

Cons of DSCR Loans

1. Terms

Expect to pay anywhere from 20-25% of the total loan value as a down payment for your DSCR loan. You’ll need to pay lender and service fees, which can range from 0.5% to 1% of the entire loan.

2. Limited financing

Although DSCR rates and terms might be comparable to other loans, they often provide less overall financing. If you need more than around $5,000,000 for your commercial loan, DSCR loans might not be your best option.

FAQ

Is it hard to get a DSCR loan?

Not at all.

In fact, because approval for DSCR loans depends on your property’s income—not your personal financial situation—it can be much easier to get approved.

The application process is faster, more streamlined, and the requirements for DSCR loans are typically less stringent.

Should I take out a DSCR loan?

If you have a business or rental property that is bringing in a solid income, definitely consider a DSCR loan.

They are an attractive option if you can’t meet the personal income requirements of other loans.

On the other hand, if you can meet these requirements, you may find better rates or terms elsewhere.

Are DSCR loans expensive?

DSCR loans aren’t the cheapest option on the market.

They typically require a 20-25% down payment.

Final Thoughts

DSCR loans are a great option if you have a revenue-generating business or property.

Because they don’t deal with your personal income, they’re an accessible option for property investment.

Interested in applying for a DSCR loan? Loanbase has you covered.

Our platform streamlines the process of matching borrowers and lenders to help you, as a borrower, find the best deal.

We’ll match you with a lender who can meet your needs and help you get the best loan on the market. Start your property investment journey with us today.

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