DSCR Loan Pros and Cons: A Comprehensive Guide for Investors

KEY TAKEAWAYS:

1. No income verification and no property limits make these loans ideal for investors with complex incomes and those looking to finance multiple properties.
2. Higher down payments and interest rates (20-25% down, 7.7% interest) make these loans more expensive than traditional mortgages.
3. Flexible property types and easier qualifications allow financing of various real estate investments, including residential, commercial, and vacation rentals.
4. Riskier but suited for experienced investors due to the requirement of a higher DSCR (1.2-1.5) and potential cash reserves, making it best for those who can handle the financial risks.

Investors in the real estate market are never short of financing options. From traditional mortgages to innovative bridge loans, there’s something for every type of investor. In this article, we are going to explore one such service - Debt Service Coverage Ratio (DSCR) Loan.

This blog contains everything from DSCR loan pros and cons to its qualifications and fundamentals. With no income verification and easier qualification criteria, the DSCR loan is a very popular loan despite its higher down payment and interest rates. Let's dive in to understand what DSCR is, its pros and cons and the qualification criteria to obtain such a loan:

What is a DSCR Loan?

A debt service coverage ratio (DSCR) can tell you a lot about a property’s financial health. It’s a ratio of the property’s owed amount (debt service) to its net operating income (coverage).[1]

A DSCR loan focuses on the property’s DSCR rather than your income. Simply put, it relies on the property’s ability to make enough income to cover the debt. This income typically comes from renting. 

Most DSCR lenders prefer a ratio of at least 1.2. Any DSCR over 1.0 means the property income can cover the debt, but 1.2 or higher leaves room for profit. For the lender, that means lesser risk. Ideally, the golden ratio would be 2.0 since the property can cover its debt two times.

DSCR Loan Pros and Cons:

When you compare the pros and cons of DSCR loan, the pros clearly outweigh the cons. Here's a more in-depth look at DSCR loans pros and cons:

Pros:

Here are seven reasons why DSCR loans should be your next financing option: 

1. No Personal Income Verification Required

In a DSCR loan, the property’s NOI covers all the debt. That means the lender doesn’t need to verify your personal income or employment details. So, if your income is complex or hard to verify, you’re in luck. 

This can also be a great opportunity for beginners since their tax returns don’t show much income. In fact, most people turn to real estate investment simply to avoid employment taxes. But that benefit makes it harder to get a traditional mortgage that requires income verification. 

2. No Property Limit

Most lenders don’t limit the number of properties you can get financed. You won’t need to pay off a previous property to invest in the next one. This can be a great option for those who want to expand their portfolio but find traditional loans limiting.

3. Easier to Qualify

This loan isn't concerned with your finances, making them much easier to qualify for. All you need to do is find a profitable property. Since you won’t need to provide too much liquid capital upfront, it even works for the self-employed.

4. Quicker Applications

Since it takes much less to qualify for this loan, they close quicker than traditional mortgages. Lenders won’t be spending any time checking your personal income or employment history. Plus, these loans often come from private lenders with the luxury of making quicker decisions.

5. No Reserves Required

If your loan is a cash-out one, it most likely won’t require any reserves of additional funds.

6. Diverse Funding Options

Beyond just financing multiple properties, DSCR loans also allow you to finance different types of properties. With traditional mortgage loans, you’re limited to residential units. Meanwhile, these loans can be used for:

• Single-family residential properties, 
• Commercial and multi-family properties,
• Short-term and vacation rentals, and so on. 

7. Approval According to the Deal

In some cases, the lender may approve your loan even if it doesn’t meet the requirements to a tee, as long as it's a great deal. If you’ve found a property you’re really confident in, you won’t need to sweat the small stuff like your credit score.

Cons:

As with any financing option, there’s always a catch. Here’s what you should know about the tricky side of these loans before investing. 

1. Higher Down Payments

DSCR loans can be fruitful, but their loan-to-value (LTV) is typically 75-80% at most. That means you’ll need to come up with a down payment of at least 20-25%. This is pricey since the average down payment for a conventional mortgage is currently 3-5% in the US.[2]

2. Higher Interest Rates

DSCR loans also have much higher interest rates than traditional home loans – around 7.7% as of March 2024. However, you can get a better rate by increasing your down payment or offering a ratio of at least 1.25.

3. High DSCR Required

Most lenders expect a DSCR of no less than 1.2. But if you want a good deal, they’d prefer 1.5, which isn’t easy to achieve in an expensive real estate market. A 1.5 DSCR means the property income can fully cover the debt and still leave 25-50% of the funds.

4. Six Months of Cash Reserves

In some cases, the renter whose rent payments are covering your debt can end their tenancy. Responsible lenders like to keep backup plans for such scenarios. For some lenders, this backup plan can be the money in your bank account.

That means you may need to keep three to six months of payments in your account. This way, you can keep the installments going while you find a new tenant. Luckily, this isn’t always the case with DSCR loans – it all depends on the lender.

5. Loan Limits

Some properties are too expensive for a simpler loan, and most lenders cap out at $1 to $3 million. If you’re lucky, you may even find a private lender willing to offer $5 million. 

Luckily, these limits are generous enough for most single-family homes, duplexes, or even triplexes. But if you’re looking into larger complexes, it’s best to go for a commercial real estate loan.

6. Prepayment Penalties

DSCR loans are not consumer products. That means typical consumer protections don’t apply, including the ban on prepayment penalties. Take your time to read the loan’s terms before you invest.

Additional Considerations

Risk and Suitability:
DSCR loans can be risky if the property doesn’t generate enough income. Investors should evaluate their property’s potential carefully. These loans are best suited for experienced investors who can manage higher costs and potential risks.

Short Comparison of DSCR Loans with Other Loan Types:
1. DSCR Loans vs. Hard Money Loans: Hard money loans typically have higher interest rates and shorter terms, but they are often easier to obtain quickly. DSCR loans, on the other hand, are generally used for long-term investments with better rates if the property income supports it.
2. DSCR Loans vs. Conventional Loans: Conventional loans require personal income verification and often have stricter credit and financial criteria. DSCR loans rely on the property's income and are more flexible but come with higher costs.

DSCR Loan Qualifications

DSCR loans are a lot easier to qualify for than other real estate financing options. Here are all the loan requirements you need to meet:

• Interest Rate: from 7.5%
• Origination fee: 2-3%
• Loan To Purchase Price: up to 80%
• Loan To Value: up to 80%
• Minimum DSCR: None
• Term: 30-yr fixed rate
• Minimum Loan Amount: $150,000
• Maximum Loan Amount: $3,000,000
• Minimum FICO: 660
• Type of Property: Residential, commercial, rental

How to Calculate DSCR Loan

To calculate the DSCR, you’ll need to know the property’s net operating income (NOI) and total debt. The NOI is the property’s income before any interest or tax. Here’s a simple formula:

DSCR = Net Operating Income / Total Debt Service 

Where:

Net Operating Income = Income − COE

COE = Certain operating expenses

Total Debt Service = Current debt obligations

FAQ:

Q1: Who can benefit the most from DSCR loans?

A: People who want to focus more on the income-generating potential of their investments tend to opt for DSCR loans. This includes real estate investors, self-employed individuals and those with complex income sources who want to choose loans with no personal income verification.

Q2: What types of properties can we finance through DSCR loans?

A: DSCR loan has versatile use when it comes to the types of properties you can manage. This includes Commercial Properties, residential properties, and Single/multi-family housing units.

Q3: Can I use a DSCR loan for multiple properties?

A: Yes. There's no limit on the number of properties you can finance.

Q4: What things should I consider before applying for a DSCR loan?

A: Considering higher down payment and interest rates, having high DSCR and cash reserves for some rare cases will make your process secure and comfortable while applying for a DSCR loan.[3]

Conclusion

If you want to start building your rental property portfolio, you’ll like the speedy, low-effort terms of a DSCR loan. These loans can be powerful for beginners who don’t want their finances to get in the way of their investment. 

Deciding on a loan depends on your goals and situation. If you value quick and easy financing and can manage the higher costs, a debt coverage service ration loan could be a great fit. But if affordability is a concern, exploring other loan options might be a better idea. To know what works better for you and your needs, our team at Truss Financial Group is ready to make your life easier.

Article sources and references: 

[1] : Investopedia: Debt-Service Coverage Ratio (DSCR): How to Use and Calculate It

[2] : Bankrate: Average down payment on a house

[3] : Nasdaq: DSCR Loans: A Guide for Smarter Real Estate Investment