If you’ve tried acquiring financing for your investment purchase but you're having trouble qualifying for a conventional loan, you might have alternatives: DSCR or No-DSCR loans. These loans have a similar concept and purpose in investment property financing, however, the key difference is that a DSCR loan requires that your debt service coverage ratio falls within a certain range, while a No-DSCR loan does not.
Let’s take a look at DSCR vs. no DSCR loans in detail.
The Debt Service Coverage Ratio Explained
To understand both DSCR and No-DSCR loans, you need to understand the debt service coverage ratio.
In a nutshell, the debt service coverage ratio is an indicator of the cash flow of a property relative to its mortgage or other operating expenses. Think of the DSCR as comparing how much money a property brings in with rent compared to how much money it costs to pay for that property’s mortgage.
Put another way, the DSCR analyzes a building’s cash flow and compares it to its ability to pay debt obligations. So, if you calculate the DSCR, you know how much money the building is likely to make in rent relative to how much money you have to pay towards debt obligations.
How To Calculate DSCR
Fortunately, calculating the debt service coverage ratio is fairly straightforward. You just need to estimate the rent value either by using current market rent value, or current lease agreement for the property in question – this will be the net operating income.
The total debt service will be your PITIH, which stands for your mortgage principal, interest, taxes, insurance, and HOA (if applicable).
To calculate the DSCR, use this formula:
- DSCR = Net operating income / total debt service
Let’s look at an example: Say that you find a rental property with two units you can rent out. If both units have paying tenants, you’ll make a monthly income of $3,000. However, that rental property costs $2,400 in terms of mortgage, taxes and insurance.
Plug these numbers into the equation, and you get:
- DSCR = $3000 / $2400 = 1.25
The debt service coverage ratio is 1.25. For comparison, this is a very good debt service coverage ratio that would indicate a property is a great rental opportunity.
What’s a “Good” DSCR?
While there is no industry standard, most lenders set their minimum DSCR between 1.2 and 1.25.
As a real estate investor, you want a building with a DSCR above 1.0 if you want to secure financing through a debt service coverage ratio loan. A DSCR of 1.0 means that the income generated from the company is exactly enough to cover debt payments. Getting your DSCR above 1.0 will provide some extra cushion and extra security for the lender, which will increase your approval odds.
What Is a DSCR Loan?
With a conventional loan, a lender will focus more on the borrower's financial profile rather than the cash flow of the property. This includes analyzing personal income history, down payment source, bank statements, current expenses, and credit history in order to determine the borrower's ability to pay back the loan in full.
For a conventional loan, the key ratio they focus on is Debt-to-Income (DTI) ratio, which calculates how much of the borrower's income goes towards paying debts and living expenses such rent, auto loans, credit cards, etc.
With a DSCR loan, in contrast, the lender will focus primarily on the income producing ability of the property to ensure it can cover monthly obligations such as the monthly payment towards mortgage principal, interest, taxes, insurance, and HOA fees. This is calculated using the debt service coverage ratio.
So, rather than looking at the borrower's personal income and expenses, a DSCR lender will only analyze the cash flow and expenses tied to the property. It's an ideal option for real estate investors that have less than stellar credit or have trouble verifying all of their income.
What Does a DSCR Loan Require?
Below is a list of what is generally required to qualify for a DSCR loan, this may vary from lender to lender:
- Appraisal with rent schedule and operating income
- Minimum FICO 640
- Asset can be one of the following:
- Single family home
- Multifamily (2-4 units)
- Non Warrantable condo
- Condo-hotel (condotel)
- Max loan-to-value 80%
Lenders may also provide an interest-only option that can help bring down the DSCR. As far as down payment requirements, gift funds are allowed to be used towards the purchase.
Why Do Lenders and Borrowers Use DSCR Loans?
Lenders like to use DSCR loans because they allow them to give money to borrowers who they otherwise would not. If done wisely, they make more of a profit each quarter.
Borrowers, on the other hand, use debt service coverage ratio loans in order to qualify for financing where they would not usually. For instance, if you are experiencing a gap in liquidity, unable to verify all of your income, or if you don’t have an excellent credit score, you might still qualify for a debt service coverage ratio loan, even if you would not qualify for a conventional loan.
What Is a No-DSCR Loan?
In a nutshell, a no DSCR loan, also knowns as a No-Ratio-DSCR loan, is a type of loan program where the lender does not factor in whether the monthly rent can cover your monthly expenses. There focus will be on the quality of the asset and the overall financial strength of the borrower.
Although the financial strength of the borrower comes into play in a No-DSCR loan, a No-DSCR lender does not require extensive income verification like a conventional lender would. That said, a No-DSCR naturally comes with more risk to the lender, and therefore is attributed to having higher interest rates and down payment requirements than a DSCR loan.
For example, a DSCR loan will allow for up to 80% financing, whereas a No-DSCR loan will allow for up to 70-65% financing.
No-DSCR loans also have less documentation requirements, are often not credit score based, and are overall easier to qualify for than a DSCR loan. This results in much faster closing times, which makes it ideal for investors who want to secure a good real estate deal fast in an area where rent prices haven’t caught up to the market yet.
What Does a No-DSCR Loan Require?
A No-DSCR loan typically requires the same things as a DSCR loan in terms of asset type, ordering an appraisal, and providing existing rent rolls, as they still want to verify that the asset is financially stable.
A No-DSCR loan will also want to confirm the borrower’s financial strength and their ability to repay the loan. As mentioned before, this won't come in the form of requesting W-2s, tax returns, or paystubs. Instead, they will likely request a copy of the applicant's personal bank statements that shows enough liquidity to cover 6-12 months of interest payments.
Bottom Line: Should You Pursue a DSCR or No DSCR Loan?
Both DSCR and no DSCR loans can be advantageous, especially if you don’t qualify for conventional financing. Generally, you should try to qualify for a DSCR loan first — if you do qualify, you’ll be able to get the financing you need to begin your investment journey even if you don’t have a lot of cash reserves. However, if you find yourself pressed for time, a No-DSCR loan can help you close as fast as a cash offer could.
The good news is that you have local mortgage firms like Vaster, that offer both DSCR and NO-DSCR loans. This mean you can explore both options at once and paired with 1:1 expert guidance to ensure you land on the financing solution that fits your investment needs to a tee.
Contact us today for more information on rates and terms. Have a quick question? Text us! Click the chat button on the bottom right of your screen to speak with a Vaster team member ASAP.
Debt-Service Coverage Ratio (DSCR): How To Use and Calculate It | Investopedia
Loan-to-Value (LTV) Ratio: What It Is, How To Calculate, Example | Investopedia
What is a credit score? | Consumer Financial Protection Bureau