Looking for a way to secure an investment property with a home loan that’s not based on your personal income? A Debt Service Coverage Ratio loan (DSCR) is a type of non-qualified mortgage (non-QM) that is based on a property’s potential cash flow – not your tax returns.
What are DSCR loans and how do they work? Read on and we’ll explain everything you need to know about DSCR loans and using them to purchase a rental property.
What is the Debt Service Coverage Ratio (DSCR)?
The debt service coverage ratio (DSCR) is a simplified calculation of rental property cash flow. It takes a property’s projected or historical income from yearly rents over the property’s PITI debt obligations (principal, interest, taxes, insurance – and HOA fees if the property has any).
The DSCR calculation is important for lenders to assess whether a property will generate enough income to reasonably support loan payments.
Psst – looking for a more thorough calculation of what kind of income a rental property will generate? Check out our popular rental property cash flow calculator that accounts for all factors.
DSCR Loans Explained
It’s important to know how a DSCR loan works in residential real estate. If you want to obtain a loan for a rental property without going through traditional income verification steps, a DSCR loan may be a creative option that works well for you.
Debt service coverage ratio loans are primarily dependent on your real estate investments having more cash flow coming in than debt going out. They provide more flexibility than conventional loans regarding the type of property you can purchase as well as how many properties you can obtain with a single loan.
A conventional mortgage loan generally takes your personal debt-to-income ratio into account. A debt service coverage ratio loan makes it possible to buy an investment property when you have low or no monthly personal cash flow available.
DSCR lenders instead look at the income a property generates to determine if its cash flow can cover its debt obligations, which means your eligibility is not as dependent on your personal finances.
DSCR loans are typically available in amounts ranging from a minimum of $100,000 up to $5,000,000. They are often used to purchase properties that are already being used as short-term or long-term rentals, but you can also apply if you want to turn a property into a rental home, renovate a property for renting, or build a new rental home.
How is Debt Service Coverage Ratio Calculated?
Debt service coverage ratio is a simple calculation that divides your rental property’s annual net rental income by its annual debt. The resulting number is the DSCR that lenders will use to determine your eligibility for a loan.
How is Annual Net Rental Income Determined?
Lenders will typically look at both an appraiser’s comparable rent schedule (see form 1007) and the property’s yearly rental income (taken from a signed lease agreement). Generally, the lesser number from the two is used.
If you’ve built up a rental history with either a long-term or short-term rental, you may be able to qualify using your historical income instead of the appraiser’s rent schedule.
How is Annual Debt Determined?
Your annual debt is just calculated from your yearly PITI payments. That’s the sum of your payments from principal, interest, taxes, insurance, and HOA fees if you have them.
Debt Service Coverage Ratio Calculation Example
Joe wants to buy a short-term rental property in a popular tourist area. He works with a top Virginia Beach real estate agent to find a great oceanfront property that will bring in $65,000.00 in annual gross income.
Joe uses a real estate cash flow calculator to determine the all-around value of the investment. He pulls out the annual debt obligations for the principal payments, interest, taxes, insurance, and HOA fees for the property that will be used by his DSCR lender and sees they are $31,861 per year.
Joe divides the annual income for this property by those debt obligations ($65,000.00 / 31,861 = ) and discovers his debt service coverage ratio is 2.04.
What’s a Good Debt Service Coverage Ratio for a Loan?
A debt service coverage ratio of higher than 1.0 shows that a property is making money and can pay its debts, but generally DSCR lenders are looking for a ratio higher than that.
Most DSCR lenders want to see a minimum ratio of 1.2 or 1.25. This assures them that you won’t miss a payment if your rental property experiences unexpected vacancies or needs a sudden repair.
A debt service coverage ratio of at least 2.0 is considered very strong and is a great goal to aim for as an investor. The higher your property’s DSCR, the more likely you are to get better loan terms. Higher ratios can mean lower interest rates and less stringency on other qualifications such as reserve cash. A higher down payment could also help you secure a DSCR loan even with a lower ratio.
Pros and Cons of Getting a Debt Service Coverage Ratio Loan:
Are DSCR loans good for real estate investors? Like any financing solution, using a debt service coverage ratio loan comes with its pros and cons to consider. Here are some factors to think about to help determine if applying for a DSCR loan is the right choice for you.
Pros of DSCR loans:
No W-2 or 1099 income requirement
Real estate property write-offs on your taxes don’t affect your ratio
Available to use for purchase of buy-and-hold investment properties
Great for purchasing a short-term or long-term rental business already in operation
Often provide a quicker closing time on your loan
Available in large loan amounts
No income or job verification needed
Available to experienced investors or new real estate investors
Can help build your real estate portfolio fast
You can close on a loan as an LLC
You can get unlimited cash out
You can take out multiple loans for multiple properties
Cons of DSCR loans:
Requires higher down payments than a conventional loan
Interest rates and fees are higher
Interest rates are reliant on your credit score
Minimum property standards need to be maintained even in times of low cash flow
Can’t be used on a primary residence or quick flip – for long-term investment properties only
Personal finances and income may need to cover debt in the case of vacancy
Requires a higher credit score than a conventional loan
Some DSCR loans may have prepayment penalties – review your terms carefully!
What are the Requirements for a DSCR loan?
Requirements for a DSCR loan may vary by lender and the type of property you are purchasing. Here are a few different considerations DSCR lenders will likely look into when you apply for a loan:
Debt Service Coverage Ratio Minimum: Your lender will have a threshold your property’s debt service coverage ratio will need to meet or surpass to qualify for a DSCR loan. Generally, they will want at least a 1.2 ratio to be sure the property will be able to cover its payments as well as unexpected expenses.
Rental History: Lenders like to see that the property is already proven to be a successful short-term or long-term rental. Get a copy of the active lease and rent agreement from the seller for a long-term rental, or a recent gross rental payout history for a short-term rental.
Property Appraisal: An appraisal that includes rental income data for comparable local properties is usually – though not always – a key factor in determining DSCR loan eligibility. This is used in the debt service coverage ratio calculation if rental history isn’t available for the property, or if estimated rent from the appraiser is lower.
Loan-to-Value Ratio (LTV): Your DSCR lender will also look at the loan-to-value ratio of the rental property, dividing the DSCR loan amount by its appraised value. In most cases, they are looking for an LTV of 75% or higher.
Credit Authorization: Though your personal income isn’t a determining factor for a DSCR loan, your creditworthiness is. Lenders will require authorization to pull a credit report to check your history. Some lenders will approve you for a loan with a credit score of 620, but they often want to see a score of at least 680.
Down Payment: The typical down payment needed to secure a DSCR loan is between 20-30% minimum.
Verification of Funds: To make sure you can cover the necessary down payment and have some reserves if there’s any issue with cash flow, DSCR lenders will need bank statements to verify your funds. You may be able to use statements from retirement accounts or stock portfolios for this.
Property Insurance: You’ll need insurance on the property to make sure the lender will be able to recover their loan funds in case of damage or destruction. If your property is in a specified flood zone, like in parts of Virginia Beach, be sure to ask if you need flood insurance as well.
Receipts from Rehab and Renovation: If you’re using a DSCR loan to refinance a property, be sure to have all documentation for the work you’ve done to renovate.
Identification: Don’t forget to bring along your government-issued identification to qualify for your DSCR loan!
Does a DSCR Loan Require an Appraisal?
It depends on the lender. Most lenders will require a property appraisal to determine its market value. As part of the appraisal, the appraiser will provide a 1007 rent schedule based on comparable rentals nearby, current rent, or rental history to prove the property’s income potential.
Be careful, if you are looking to get a loan based on short-term rental income with a qualified mortgage product - the appraiser will not be able to use short-term rental income projections in their rent schedule.
What Kinds of Properties Can a DSCR Loan Be Used For?
DSCR loans are designed for the purchase of rental properties. Both short-term rental and long-term rental properties can qualify for DSCR loans.
DSCR lenders can help you to buy a property currently being used as a rental property, to construct a new investment home, or to renovate your current property.
In some cases, you may be able to get a DSCR loan to purchase a secondary residence if you plan to rent the house out at all. This might be through seasonal rents, renting out a part of the property long-term or short-term, or allowing people to rent it as an event venue.
Many types of property can qualify for a debt service coverage ratio loan, such as single-family homes, townhouses, condos, or even multifamily properties.
Where Can You Get a DSCR Loan?
Because DSCR loans are Non-QM loans and not conventional loans, your personal credit union or bank may not offer them. When determining where to get your DSCR loan, look for lenders who work with the non-QM loan niche.
DSCR loans may come from mortgage brokers, private lenders, and certain banks and credit unions. Because they aren’t government-regulated like conventional loans, the conditions and requirements will vary from lender to lender. It’s a great idea to compare reviews and offerings of several DSCR lenders before settling on one to use.
Are DSCR Loans Fixed Rate?
Yes, debt service coverage ratio loans are generally fixed-rate loans with a consistent monthly payment. The most popular amortization period is 30 years, but many DSCR lenders provide ]other options.
An interest-only DSCR loan allows investors to pay only the interest on the loan for the first 5, 7, or 10 years. After that, principal payments are added, typically at an annual or semi-annual adjustable rate for the remainder of the life of the loan.
Can I Close a Debt Service Coverage Ratio Loan Faster?
DSCR loans can be a great option if you want to close quickly on a loan. The application process is generally faster than a conventional loan. They also require less paperwork; you don’t need to provide employment verification, W-2s, 1099s, or tax returns. So yes, it’s very possible to close more quickly on a DSCR loan.
How Many DSCR Loans Can You Get?
There is no limit to the number of DSCR loans one borrower can have. This is especially if you are seeking to purchase multiple properties at the same time.
Conventional loans do limit you to ten properties; not so for a DSCR loan. Conventional loans also typically only allow you to commit to a single property at once.
Do DSCR Loans Show Up on a Credit Report?
Credit reporting practices vary from lender to lender regarding DSCR loans. Make sure to ask your lender about the specifics of how your loan will affect your credit.
If you manage your loan properly, it often will not affect your credit score. Many lenders will do a soft credit pull rather than a hard pull, which is one specific question you can ask about when you apply.
This also means that paying off your DSCR loan responsibly may not enhance your credit score. And, if you default on a DSCR loan, you might find that negatively affecting your personal credit report.
While a DSCR lender primarily wants to know if the property will generate the necessary income and isn’t as interested in your personal cash flow, your creditworthiness is considered. If you have a poor credit score or a history of defaults, that could affect your eligibility for a loan. Better credit can also help you get better interest rates on DSCR loans.
Can You Get a DSCR Loan for an Airbnb?
Yes, it’s possible to get a debt service coverage ratio loan for an Airbnb property.
Just like with other short-term rental DSCR loans, the bank or lender will be looking at your debt service coverage ratio to make sure that your Airbnb will earn more than its debt payment each month.
When securing a DSCR loan to finance an Airbnb, VRBO, Homeaway, or similar property, it helps if you have some history as a host. Additionally, lenders can look at similar rental rates in the area your Airbnb is located, sometimes using a tool like airDNA.com.
Do your research when applying for a DSCR loan for an Airbnb or other short-term rental. Many lenders require higher down payments or increased interest rates for properties that rent short-term contracts.
Airbnbs and similar vacation hosting properties tend to be able to charge increased nightly rates, but vacancy rates may also be higher. If you are dependent on a DSCR loan for an Airbnb property, look for a rental that has a history of high demand. Popular tourist areas, like a rental paradise such as Virginia Beach, are a great place to look.
Can You Get a DSCR Loan with No Down Payment?
No, you can’t get a DSCR loan without a down payment. You’ll need to put some money down to qualify.
Certain DSCR lenders may be willing to give you a loan with as little as 15% down, but more often you’ll be asked for a 20-30% down payment to qualify.
Remember: if you put more money down, you’re likely to have lower monthly payments and fewer total interest payments.
Can You Apply for a DSCR Loan as an LLC?
Yes, you can qualify for a DSCR loan in the name of your LLC. To protect against a default in these cases, most lenders will require every majority owner of the company to act as a guarantor of the debt service coverage ratio loan.
In addition to the above DSCR loan requirements, your lender may require you to include certain entity documents with your application, such as your LLC’s operating agreement, certificates of good standing, a certificate of formation, or your articles of organization.
When you get a DSCR loan as an LLC, it typically doesn’t show up on your personal credit report. This can be a plus for those who don’t want to add more debt that will impact their creditworthiness.
The Bottom Line
A DSCR loan can be a creative way to finance your next investment property. With no personal income verification, a DSCR loan can be a creative way to finance one or multiple investment properties at the same time. However, it is important to know that every lender offers different terms for a DSCR loan, so it is imperative to find the right one for you.