What is a Rental DSCR Loan?
Don’t know what a DSCR loan is? Find out what it is and how it can work for you!
So, you’re thinking about getting into the real estate business, and you’re wondering how to get a loan for a rental property. First things first; good for you! Second things second; you’re definitely going to need to know what your DSCR is.
“Wait,” you’re probably saying to yourself. “What is a DSCR? That sounds…ominous. I’m scared.”
It’s okay. We get it. It sounds intimidating, but it’s really not. DSCR simply stands for “debt service coverage ratio.” It’s a formula used to determine if there is enough cash flow from rental income received on the property to “cover” or “service” the outstanding monthly expenses and payments on said property. Your DSCR will not only determine whether you get financing for a property in the first place, but it will absolutely determine whether your investment will be successful over the long term.
It’s crucial that you know your DSCR in order to properly evaluate the profit potential (as well as potential risk) of any rental property you might be acquiring. The formula for calculating debt service coverage ratio is pretty straightforward. The DSCR for real estate is calculated by dividing the monthly rental income of the property by the monthly expenses. Monthly expenses include the principal, interest, taxes, insurance, and sometimes homeowner’s association fees. This is known as PITIA.
Usually, anything between a 1.1 and 1.2 DSCR calculation (meaning the rent is 100 to 120% of the monthly expenses) is considered a sufficient cash flow to cover the outstanding monthly debt.
If you are below 1.0, well, that means the property doesn’t generate enough cash flow to cover its debt obligations but, not to worry, we still have a No DSCR option available! Still, the higher your DSCR metric is above 1.0, the more likely there’s enough of a cash-flow cushion to cover debt obligations, which is the sweet spot you really want.
Now that you understand that, you might be wondering what exactly a DSCR loan is and how it compares to a conventional loan. Are DSCR loans better than conventional loans? Are they worse? Great questions and we’re glad you asked them!
The main benefit of a DSCR loan is that it allows mortgage lenders to focus more on borrower credit and property cash flow and less about the borrower’s personal income. When investing in real estate with a DSCR loan, you don’t need proof of income via tax returns, W2’s or pay stubs because either you don’t have it, or your income doesn’t represent your true income due to write-offs and business deductions. The process and documentation requirements for DSCR loans are also much less restrictive than conventional loans. Because of this, we can fund loans much faster than conventional lenders. We can fund as quickly as 10 to 14 business days. Yeah…that is crazy fast!
An additional benefit of a DSCR loan is that many mortgage lenders will allow borrowers to purchase properties in the name of an LLC or corporation which is typically something that conventional lenders will not allow. This is highly beneficial to investors as holding a property in an LLC has potential tax benefits to the investor and reduces exposure from a liability standpoint.
Lastly, DSCR loans do not report to the three main credit bureaus (Experian, Equifax, and Transunion). As a result of this, these loans do not affect your Debt to Income Ratio that conventional lenders look at. We don’t even look at your Debt to Income Ratio! How amazing is that?!!
We know, it’s kind of a win-win. (It might actually be the very rare win-win-win.)
Now, with conventional loans, there are very specific underwriting guidelines that each loan needs to meet. Income, assets, credit, and collateral are all carefully reviewed to make sure that each loan meets proper guidelines so that it can be a loan that will be “saleable” to Fannie Mae or Freddie Mac, who packages these loans as mortgage backed securities (MBS) and sell these MBS’s to investors around the world.
Another restriction of conventional loans is that Fannie and Freddie do not allow investors to buy properties in the name of an LLC and they also have a restriction on how many investment properties one person can own. You may get a lower interest rate with a conventional loan than with a DSCR loan, but it will be way more time consuming and much more of a difficult process for the borrower to get the loan approved.
Once you’ve figured out that a DSCR loan is the way to go for investing in real estate, you can then utilize the DSCR formula when you are shopping around for rental property investments. Armed with this knowledge, you’ll be able to make smarter decisions when you buy real estate as a rental property investment. See? That wasn’t so scary now, was it?