As a real estate investor, you know the trials that come with securing a loan for an investment property. Too often, traditional lenders determine eligibility based on personal income. Moreover, investors take deductions on tax returns that reduce taxable net income, which can have an adverse impact on mortgage loans.
However, investors have a variety of opportunities, such as DSCR loans, to leverage. DSCR loans help real estate investors of any experience level purchase a property and grow their portfolios. Unlike traditional mortgage loans, DSCRs do not require specific proof of income.
Instead, REIs qualify based on cash flow, providing them with faster closing times and flexible solutions for funding flips.
So, what is a DSCR loan, and how do you know whether it’s the best option for your next project? These loans make it easier to qualify based on income, which allows investors to reach ROI more quickly. Below, we take a look at the risks and opportunities that come with these loans.
If you find you still have questions, our team is always willing to help you find the right solution for your situation.
What Is a DSCR Loan?
DSCR stands for debt service coverage ratio. It’s a metric lenders use to determine whether someone can repay their loan. Typically, a real estate investor has a lower net income once they deduct expenses from their taxes.
Unfortunately, that impacts their ability to secure a conventional loan. Generally speaking, traditional mortgage lenders have strict requirements that they follow. This prevents them from providing loans to many REIs.
However, a DSCR makes it much easier for an REI to qualify on a loan for an investment property based on cash flow, such as rental income, instead of their job history or personal income.
How to Calculate DSCR
To calculate DSCR, you divide the gross rental income by the debt service. The product is a decimal that tells you whether a property has a high enough income for you to repay the loan.
DSCR = Gross Rental Income / Debt Service
How Does a DSCR Loan Work?
A DSCR is specific to real estate investors. It is not meant for someone to purchase their primary residence. Instead, it allows an REI to purchase and renovate a short or long-term rental property, which can apply to apartments, condos, townhomes, and houses.
The DSCR is a calculation that tells your lender whether you will be able to repay your loan with the rental income. If your DSCR is 1, it tells your lender that you will have exactly enough income from your investment to repay the loan.
However, that’s not an ideal figure because there are other obligations as a landlord that result in expenses. From maintenance and repairs to employees and contractors, there are many factors to consider.
So, lenders typically look for a higher DSCR, such as 1.25, as proof of your ability to repay while maintaining extra cash flow to cover expenses. The higher the figure, the more appealing it is to lenders. In turn, you are more likely to qualify for higher loan amounts.
What DSCR Do Lenders Accept?
DSCR requirements vary from lender to lender. While many look for 1.25, there are other lenders who work with higher-risk projects to offer more flexibility. Still, it’s important to increase your ratio as much as possible for a few reasons.
- Reduce interest rates
- Ensure you get the loan you need
- Gain a proper calculation that provides a cushion for your profits
While lenders don’t look at your personal income, there is documentation to review to ensure the cash flow meets any DSCR loan requirements. To apply for these loans, it’s important to show a signed lease agreement with current rental income. Alternatively, you might show an appraisal of your investment property.
Benefits of DSCR Loans
- Faster approval process: Typically, DSCR loans have a faster application and approval process, which is good for real estate investors who need a quicker turnaround to take advantage of opportunities.
- Continuous cash-out: With a DSCR, you have the option to take out additional funds when you need to cover expenses such as renovations or repairs.
- Accessibility: The ratio is the main factor for eligibility, which allows REIs to bypass personal income limitations.
- Flexibility: REIs can use a DSCR for any type of rental property, including short-term rentals and long-term rentals, as well as any type of property.
- Multiple properties: Investors who use this type of loan have the potential to work with multiple properties at once. While traditional loans don’t allow an investor to purchase another property until they repay the debt, a DSCR program allows you to build out your portfolio.
Risks of DSCR Loans
As with any type of loan, there are pros and cons with a debt service coverage ratio loan. It’s important to understand both so that you can find the best financial solution available to you.
- High interest rates: The rates with DSCR are higher because the loans carry an inherent risk, as any investment does.
- Rental investments only: These loans are specific to rental properties, not to purchase your primary residence or flip a property. The goal is to generate cash flow continuously.
- Limited financing: These loans offer amounts up to $5,000,000. When your goal is to purchase a property in a more expensive market or to buy multiple properties at once, you may need a different loan.
- Higher down payments: Often, lenders require a sizable down payment, which may be higher than a conventional mortgage.
- Vacancies at the rental: It’s common for a rental to have vacancies at times. Unfortunately, that means reduced cash flow. Lenders don’t always take this into account, so a vacant property can impact your ability to repay the debt.
Are DSCR Loans Right for Me?
With a clearer idea of the opportunities and risks associated with DSCR, how do you know whether it’s the right way to fund your next project? Keep in mind that these loans are specific to rental properties.
Whether you are a new or veteran investor, a DSCR loan is a good option to consider. This is because it allows you to qualify based on rental income instead of your personal finances.
If you are a novice real estate investor, this type of loan can help you reach your financing goals to fund your first project. For veteran investors, it’s a good way to finance projects and increase your rental income.
While no loan option is perfect, whether it’s a good fit depends on your goals, situation, and project. If it doesn’t seem like a good fit, work with a lender who can help you find the right solution for you.
Ready to Start Your Next Project?
With DSCR loans, investors have a way to build out their rental portfolio without worrying about the limitations of traditional mortgages. Instead, fund your next project quickly and easily so that you can benefit from a streamlined timeline.
Contact the team at King James Lending today to learn more about our loan options. Let us help you find the best solution for your funding woes. Call us or apply for a loan with King James Lending today.