How To Use Pro Strategies To Save More & Make More

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In January, we published an article about DSCR loanA product that is being used by more and more real estate investors to grow their portfolio.

Known for easy qualifications and light documentation standards (no income verification, no DTI requirements, no tax returns, etc.), sophisticated real estate investors continue to use DSCR loan options after maxing out on traditional financing options. or only find that it is not worth the business. The time and hassle of bank qualifying for slightly lower rates.

The previous article outlined the basics of how to best position yourself as a DSCR borrower to get the best rates and terms on your DSCR loans. Quick recap: Rates and terms are primarily driven by three main metrics:

1. loan-to-value (LTV) ratio
2. Debt-Service-Coverage-Ratio (DSCR) Ratio
3. FICO / Credit Score

While the rate you are quoted is going to be primarily driven by those three factors, there are many other parts to the puzzle that can change the terms offered as well. The prudent DSCR loan borrower will use all options available to optimize the terms, especially in a volatile rate environment like today’s, where every little bit of rate counts in securing a profitable investment!

This article will walk you through more advanced strategies real estate investors can use to lower their rates on DSCR loans and secure the best long-term financing for their portfolios.

prepayment penalty

The best way to get the lowest rate DSCR loan is to allow the lender space prepayment penalty Provision in loan. Essentially, this means that for the first few years of the term (DSCR loans are pretty much universally 30-year loans), you will be charged a fee if you choose to pay off the loan early by selling or refinancing the property. Pay equal to a lower percentage of the outstanding loan amount (usually in the range of 1-5%).

If your DSCR loan has a prepayment penalty, your rate can typically be significantly lower – a full 100 basis points (1%) or more depending on the structure (the length of the prepayment penalty period plus the amount of the penalty fee). Why are DSCR lenders willing to give you better rates if there is a prepayment penalty? This is because most DSCR loans are securitized Or pooled in mortgage bonds for investors such as pension funds or insurance companies that rely on consistent and predictable cash flows – which would be jeopardized if too many loans were prepaid too quickly.

Prepayment penalty structure options will vary from lender to lender. However, the most common are “stepdown” structures, such as the “5/4/3/2/1” structure, which means that if prepaid during the first 12 monthly payment dates, the fee is 5%. If prepaid during the next 12 monthly payment dates, the fee is 4%, and similarly no fee is applicable if the loan is prepaid anytime during the last 25 years of the 30-year term.

This structure can be shortened to a “3/2/1” or “2/1” option with the same general concept as reducing penalties. There are some additional structures that are a bit harsher such as a fixed 5% penalty for five years (instead of reducing the fee percentage per year), but this structure is generally well paid off by the lender with lower rates! Many lenders will have the flexibility to adapt these structures, but will typically limit any prepayment penalties to 5% and any penalty period to no more than five years.

So how to avail prepayment penalty as a DSCR borrower? The good news is that DSCR loans are built for investors with a long time horizon, building a portfolio over a long period of time to earn cash flow and appreciation. Thus, if you are a typical investor who uses DSCR loans to build a cash flow “financial freedom” portfolio, you are probably not planning to sell the properties within the five-year period – so look at the prepayment protection. Getting slapped (which probably won’t impress you) is a great lever to pull!

What About Refinancing When Rates Come Down? While the prepayment penalty may hurt if rates drop in the first few years of your loan and you’re looking to refinance to a lower rate, the penalty amount is usually small enough that refinancing is still a good economic proposition. Let there be a decision. according to FHFASince 2000, average annual home price growth has been 4.7%. So if rates do indeed fall, your 1-5% prepayment penalty is likely to be more than offset by the equity you can cash-out from your decreased rate and increased value!

Loan Structure: Fixed Rate vs. ARM

A more advanced option for real estate investors using DSCR loans is to consider using a fixed rate structure versus the ARM (adjustable rate mortgage) option. However, it is extremely important to understand this structure and all the nuances as it can get confusing if you don’t do your research. In addition, there is much confusion and misunderstanding today about ARM options for DSCR loans and some of the ARM structures of the early 2000s that helped facilitate the mortgage meltdown of 2008.

Here are some quick things to know about ARM DSCR loans:

• While these are sometimes called “5-year ARMs” or “7-year ARMs,” they are still 30-year mortgage loans. The number for an ARM usually refers to the initial portion of the term where the rate is fixed, rather than the full term.
• Unlike the early 2000s when ARMs began to float rapidly, the DSCR ARMs are more of a hybrid product, described as “definitive to ARMs” while, as discussed in the bullet point above, the term introduced To have a fixed rate for a significant period, typically five or seven years.
• These are usually expressed as two numbers separated by a slash – such as “5/1” or “7/6.” The first number refers to the early years of the period for which the rate is fixed, while the second number refers to the frequency of rate adjustments after the fixed rate period. Note that this part is confusing. “6” refers to a swim every six months, while “1” refers to a swim every one year. Confusing (or poorly structured industry-standard terminology) is another reason why it’s so important to really make sure you understand your terms and structure when going with an ARM DSCR loan!

DSCR ARM loans also come loaded with provisions to set the interest rate after the initial fixed rate period. The rate is usually converted to a number that is equal to a pre-determined “margin” plus an index number such as the Secured Overnight Financing Rate (SOFR). Additionally, the floating rate is subject to a floor (usually your initial fixed rate) it can never go below, a ceiling (usually your initial fixed rate plus 5-6%) it can never go above as well as periodic rate adjustment caps to prevent rate shocks or large rate changes on a payment date.

So how to take advantage of ARM options as a DSCR borrower? You can generally get a lower rate (12.5 to 37.5 bps now typically) with an ARM instead of a 30-year fixed-rate loan, which may be worth it depending on your risk tolerance, general outlook, and personal investment plans and goals. It is possible If you’re convinced that rates will be low or stable over the five-year time frame (most economists hold this view), this could be a smart move. Remember from the section above- the prepayment penalty will not exceed five years, so there will be no prepayment fee with a DSCR loan refinance after the initial fixed rate term.

Long-Term Rental Qualifications Versus Short-Term Rentals

The biggest trend in real estate over the past few years has been investors turning to long-term rentals versus short-term rentals, primarily for the significant difference in cash flow and profitability (STR is typically double that of long-term rentals). earn). However, many DSCR lenders view short-term rentals as risky and prone to cash flow and viability disruptions due to over-reliance on overeconomy, seasonality, regulatory risk, and cost and sophistication to operate a well.

The current trend among DSCR lenders is to either stop lending on short-term rental properties, to qualify these properties only based on how they will perform as long-term rentals, or to charge higher if the property has a STR. charge rate. Hence a good strategy for an investor looking to stick with STR is to pick properties markets that cash flow If used as a long-term or short-term rental, thus allowing the lender to generate a rate consistent with a “safer” long-term rental property, which is likely to be significantly lower.

Strategic LLC and Entity Structures

A final advanced strategy is to strategically structure the borrowing entity to maximize credit. One of the major advantages of DSCR loans versus traditional financing is the ability to borrow through an entity such as an LLC. While there are pitfalls to avoid, investing in real estate with a partner or partners who have complementary skill sets is a tried and true recipe for great success in real estate investing.

As discussed in the original article, your credit score is one of the main three factors for determining rates and terms. The “qualifying credit score” used by the DSCR lender to generate your rate may differ depending on the lender if the borrowing entity has multiple owners (for example, 50/50 owners of an LLC). Some DSCR lenders will use the lower or two median scores, while some will use the higher one.

Additionally, strategic ownership structures where inexperienced or poor loan borrowers are limited to more than 25% ownership will not be credited and will not negatively affect eligibility.

Comment: Don’t cross the line between strategic unit structure and “straw borrower, Having otherwise unwilling parties as part of the LLC and loan guarantors just for the sake of creditworthiness is the fastest way to cancel your loan and get into potential legal trouble for mortgage fraud!

conclusion

DSCR loans are becoming increasingly popular due to the flexibility versus the standardized requirements of traditional financing. The ability to customize the structure to fit your investment needs allows borrowers and lenders to work together for win-win loans and long-term relationships.

Hopefully, this article helps you understand how to best structure your loans and choose a DSCR lender that allows you the flexibility and options you need. Every bit counts in this volatile market!

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