What They Are and How to Get the Best Terms

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In recent years, a brand new loan product: Debt Service Coverage Ratio (DSCR) loans, has become extremely popular among real estate investors. DSCR loans have become an important tool for investors to achieve their dreams of financial freedom.

These loans are specifically for investment properties. In collegeare so effective and popular because they need No income verification (or debt-to-income ratio) and no tax returns or endless paperwork, In addition – while qualifications and documentation are much lower than traditional mortgages – interest rates are barely higher (typically less than 1% higher). These loans offer fixed rates for 30 years, including options where it’s interest only for the first 10 years, so you avoid the repayment and refinancing pressure that often comes with hard money options.

Put together, it is no wonder why investors flock to these loans to grow their portfolio and achieve their dreams of financial independence.

How do you qualify for a DSCR loan?

Potential borrowers can sometimes face confusion when first learning about DSCR loans. especially, qualification process, especially if they have been in the ring with a traditional qualification. While traditional lenders will check every aspect of your income, expenses, bank account transactions and credit history – DSCR loans are different, as the qualification and underwriting are primarily focused on the asset rather than you, the borrower.

DSCR lenders will look at your credit score and make sure you have a few months’ payments in the bank, but other than that, your property qualifies, you don’t! This means that your sources of income, whether you have a W-2 job, own a business, invest full time in real estate, or are retired or between jobs, No problem! DSCR lenders do not strictly take income into account!

What determines my rate and terms?

So what determines whether you qualify and what rate you will pay? This mainly comes from three key factors:

1. DSCR (Debt-Service-Coverage-Ratio)
2. LTV (loan-to-value ratio)
3. FICO (credit score)

Debt Service Coverage Ratio (DSCR)

It should come as no surprise that the DSCR metric is important for DSCR loans. The debt service coverage ratio measures the income from the property (rent) divided by the principal expenses (principal and interest on your mortgage loan, as well as property taxes, insurance, and any applicable HOA dues).

real estate investors in general Invest for monthly cash flow From their rental properties, which they get when the income exceeds their expenses and they are left with a profit. A DSCR of 1.00x means that income equals expenses, and the investor is even. A DSCR above 1.00x means the investor is making money because they now have cash flow. For example, a DSCR of 1.25x would occur if the property earns $1,250 per month in rent and has $1,000 in PITIA (expenses – principal + interest + taxes + insurance + union dues). A DSCR of less than 1.00 times means that expenses exceed income, so the investor is losing money every month.

How does it work from the lender’s point of view? A lender typically wants to provide the investor with the most cash flow possible because the primary concern is the ability to make payments on the mortgage loan. Therefore, the higher the DSCR, the better lending terms an investor gets as the lender can be more assured of getting paid back as the rent more than covers the loan payments every month!

loan-to-value ratio (LTV)

the second determining factor is loan-to-value ratio (LTV). This is a simple metric comparing your loan amount to the value of the property. This is extremely important to the lender because if you stop making payments (default) on the loan, the lender’s main recourse is to foreclose on the property and replace the money lost on the unpaid loan with real estate assets. Simply put, if the lender can sell the property for more than the amount owed in the event of foreclosure, the lender is protected from losing any money.

Thus, the lower the LTV, the lower the risk of loss for the lender, as they have a larger “cushion” in case foreclosure is required. For example, in an 80% LTV scenario (say, a borrower buys a property and puts 20% down), a $1,000,000 property would have $200,000 of debt with a $200,000 “cushion” or equity for the borrower. In this situation, if the borrower defaults and the lender is required to foreclose, the lender is exposed to the risk of loss unless the property declines in value by more than 20% ($200,000). is saved, because then they would own an asset worth more than the canceled debt.

In this example, if the property retains this $1,000,000 value and the lender forecloses due to default, the lender actually owns the property for $1,000,000 instead of the $800,000 note. However, in the real world, it’s not that simple (as all real estate investors know all too well!), because of the closing costs, legal fees, and time and energy spent in the process that almost all lenders prefer to avoid. will do.

So how does this affect the terms of borrowing? Simply put, the lower the LTV, the better the terms for the borrower, as it increases the “cushion” for the lender in case of declining value and foreclosure. In the above example, the lender would have to reduce the value of the property by more than 20% to lose money, an unlikely but plausible scenario. However, if the LTV was 60%, i.e. a $600,000 loan on a $1,000,000 property, the lender would have to decrease the value by a whopping 40%, or $400,000, to be at a loss. Not very likely! Thus, the lender can offer better terms (such as lower rates) on a 60% LTV loan because it carries much less risk.

FICO (credit score)

The final key to qualifying for a DSCR loan is your FICO or qualifying credit score. Typically, there are three credit scores for everyone, Equifax, Experian and TransUnion, and the score used to qualify for the loan will be the middle one.

While DSCR loans are primarily based on the asset rather than the individual borrower, the lender still looks at the credit score as part of the bigger picture of eligibility. Note that a mortgage lender’s credit score will be calculated a little differently than the score you might see from a typical bank or online data provider. These scores are weighted slightly more toward real estate credit, taking things like other mortgage loans into account more.

From the lender’s perspective, someone with a long and great history of on-time and full payments on other mortgages is a great indicator of your likelihood of making accurate and timely payments on your DSCR loan. So better credit, better terms.

Other factors that determine eligibility

While the “Big Three” metrics listed above are the main determinants for your eligibility and rate – other factors make a difference, although not as significantly. Some other factors used by DSCR lenders include:

• Purpose of Loan: Typically, you’ll get better terms on an acquisition than on a cash-out refinance, since the price used by the lender is more certain on the purchase, and the borrower has more guaranteed “skin in the game.”
• Loan Size: DSCR lenders typically prefer a “Goldilocks sweet spot” loan size, neither too big nor too small, for the best pricing. This is because the market for supersized rental properties is low (i.e., how many potential buyers or renters are there for a $3M+ mansion), but conversely, very low-priced properties (worth $200k or less) signal a decline. or a hyper-rural market, rough neighborhood or property in poor condition. The best rates and lowest fees typically fall in the $250k – $750k loan amount range.
• Prepayment Penalty: The DSCR is known to offer lenders the best rates when the penalty for loan prepayment (i.e., a fee if you pay off early) is high. If you’re a long-term investor and don’t plan to sell quickly, it’s often a good idea to trade the prepay penalty for a very low rate within the first five years.

How to choose a DSCR lender

Once you are ready to take out a DSCR loan – it is time to choose the right lender for you. Sometimes it can be overwhelming to figure out how to start and which one to choose. There are many DSCR lenders offering products out there.

Here’s a secret about DSCR loans that many lenders won’t tell you: The loan product is mostly the same among lenders. While there are some differences along the edges and with the exact interest rates, most of the time, the loans are more or less the same. And when it comes to rates, one lender may have the best rates at a given point in time, but as in all competitive markets, this won’t last long, and rates will eventually become essentially identical.

So how do you choose the right DSCR lender to establish a long term relationship, not just for your immediate deal?

you really want to hone feature and difference in loan programs offered and reputation and financial strength Lender’s too. Rates and fees are likely to be quite similar, so be sure to ask good questions and find out why they differ.

Some suggested questions to start with:

• Are you a direct lender that lends your own capital or a brokerage intermediary that works with other lenders?
• Do you have any special programs for the type of property, such as short and medium term rental financing? Any BRRRR Lending Program?
• What is the maximum LTV you lend?
• Do you need at least 1.00x DSCR, or do you have options for non-cash-flowing assets?
• When partners (i.e., 50/50 owners of the LLC) borrow on the DSCR loan, do the higher or lower partner’s FICO score qualify?

conclusion

Selecting a DSCR lender and then ensuring your qualifications get you the lowest possible rates and fees can be an overwhelming experience. Hopefully, this article can serve as a strong resource to help you select the best DSCR loan for your investment journey.

Note by BigPockets: These are the views expressed by the author and do not necessarily represent the views of BigPockets.