Are you searching for a home loan product that doesn’t require tax returns to qualify? This isn’t uncommon if you’re a real estate investor seeking flexible mortgage solutions that don’t come with stringent eligibility criteria, extensive underwriting and drawn-out approvals.
A Debt Service Coverage Ratio (DSCR) loan could be a viable option worth considering. Read on to learn more about how they work and where to find these mortgage products.
What is the Debt Service Coverage Ratio?
The DSCR includes a property’s annual net operating income and mortgage debt (principal and interest). It’s used to gauge cash flow from a property and how much of the income can be allocated towards the monthly loan payment. A higher DSCR helps you qualify for loans and get lower interest rates.
How to Calculate Your DSCR
The debt service coverage ratio is straightforward. Every financing company offering this no-income loan will give this ratio a close look. Knowing the formula and how it works can help you avoid high rates and end up with a better long-term loan.
The DSCR Formula
You will have to know a property’s cash flow and the monthly mortgage payments on the total debt service. The total debt service reflects how much you owe in debt for a property in a given year.
Here’s the formula for the ratio:
DSCR = Net operating income / total debt service
If a property’s net operating income is $100,000 per year and debt payments come to $50,000 per year, you have a 2.0 DSCR.
What is a Good DSCR Ratio?
A DSCR ratio above 1.0 indicates the property is breaking even. Some real estate investors will be happy with breaking even since the mortgage payments will eventually go away.
However, financing companies want to ensure that loan repayments happen without issues. A 1.0 DSCR doesn’t give them any room for error, so they usually request a 1.25 DSCR or higher. A higher DSCR ratio will increase your maximum loan amount.
The Role of DSCR in Mortgage Lending
Traditional lenders often do not have eligibility requirements that align with real estate investors and self-employed workers. Real estate loans make properties more accessible to beginners and experienced investors. However, mortgage lenders still have to mitigate risk if they use DSCR loans. Here’s how lenders look at the important ratio.
How Lenders Use DSCR to Access Risks
DSCR mortgage lenders aren’t looking at traditional metrics like your personal finances or monthly income. When these lenders work with clients, they have to focus on a property’s income and the likelihood of the monthly expenses getting covered.
The DSCR ratio helps lenders assess a property’s profit margins and determine if those payments are likely to continue. Lenders value a long-term tenant that makes steady monthly payments. These types of tenants are more common in commercial real estate, but it’s also possible to find them in residential units.
A DSCR ratio of 1.0 does not give the lender much safety. Any maintenance repairs, rising property taxes, and other expenses can derail an investor’s ability to cover loan payments with rental income. However, an elevated DSCR ratio offers a greater margin of safety for the lender.
Impact of DSCR on Loan Eligibility
A higher DSCR will make it easier for you to qualify for a loan. Some investors opt for lengthier loans to reduce their annual mortgage debt. That way, investors inflate their DSCR ratios and give themselves a better chance of getting approved.
What is a DSCR Loan?
A DSCR loan is a mortgage product that caters to real estate investors. This non-QM loan features a streamlined approval process that doesn’t involve traditional income verification. Applicants must demonstrate that the property’s cash flow can exceed the monthly mortgage payments.
Mortgage lenders will want some reassurance that you can cover the mortgage payments even if you encounter a few surprises along the way, such as higher property taxes or operating expenses. That’s why most mortgage lenders want a debt service coverage ratio of 1.25 or better. In other words, if the monthly mortgage payment is $1,600, then the property should be projected to generate at least $2,000/mo in rental income. That will result in a good DSCR ratio.
Opting for a lengthier loan term will increase the likelihood of getting approved since longer terms result in lower monthly mortgage payments. This type of loan is a great resource for first-time investors and seasoned professionals.
How DSCR Loans Work
It’s not uncommon for real estate investors to write off a sizable amount of expenses on their tax returns. However, this can be problematic when applying for a traditional mortgage, as lenders generally use the net income of self-employed borrowers. However, lenders offering these loan products focus on the DSCR instead of determining your eligibility for a mortgage. If the property generates a sufficient net operating income (NOI) to cover the debt, you can use a DSCR loan program to purchase the property. Lenders look at a property’s rental income potential instead of your financial situation.
DSCR Loan Requirements: How to Qualify for a DSCR Loan
It may sound odd to hear that a lender won’t ask about your personal income. Lenders won’t even check your personal debt-to-income ratio since it doesn’t matter for profitable real estate investments. As long as rental income exceeds expenses, investors can keep it going indefinitely. DSCR lenders also provide more flexibility.
If you want to buy a property with more than four units or a non-warrantable condo, you can get the financing you need with a DSCR loan. Investors cannot obtain conventional mortgages for these types of properties. You can accumulate as many properties as you desire as long as you find rentals with favorable DSCRs.
While a DSCR loan program is an attractive option for investors, you have to qualify first. Acing these critical factors will make it easier to get the type of loan that you want.
Debt Service Coverage Ratio
This critical ratio determines if you can qualify for a loan. You can check all of the other boxes, but a low DSCR will prevent you from getting this loan. Most lenders want to see a 1.25 DSCR before approving an application. DSCR loan interest rates are influenced by the property’s ability to generate a good ROI. A better ratio can lead to some of the best rates and an easier path to approval.
Loan-to-Value (LTV) Ratio
Whether you go to a local bank or an online lender, you will likely need a loan-to-value ratio below 80%. If you want to buy a $1 million property, your mortgage balance cannot exceed $800,000.
Credit Score
You will need good credit and a high down payment to get a loan. Most lenders will provide financing if you have a 640 credit score, but a higher score entitles you to a lower interest rate.
Property Type and Use
You can only get a DSCR ratio for a rental property. This loan is not a good option for a primary residence. You must demonstrate that the property’s cash flow can exceed the monthly mortgage payments. You can get a DSCR for commercial, residential, or mixed-use properties.
Down Payment
You will need to put down at least 20% to get a mortgage. Although putting 20% down for a traditional mortgage is a good idea, you can get a home with as little as 3% down. DSCR lenders do not provide this option.
Documentary Requirements
While DSCR loan programs can help investors scale their rental property portfolios quickly, lenders won’t simply take your word for it that a property can generate enough cash flow to meet their DSCR minimum. Instead, they will request a signed lease agreement to see the current rental income or a property appraisal if you cannot provide a signed lease agreement.
Can You Refinance a DSCR Loan?
Want to refinance a DSCR loan? You’re in luck. Borrowers can refinance their DSCR loans at any time. DSCR refinances provide versatility and can help you on your real estate investing journeys. Here are some notable ways to refinance a DSCR mortgage.
- Cash-Out Refinance: Investors can tap into their equity and get cash out of their loan. Some investors use this strategy to get extra capital to make a down payment on another DSCR loan. You will gradually pay off your loan each month as your rental income exceeds the mortgage and other expenses. Tapping into the built-up equity lets you gain leverage and add more properties to your portfolio sooner.
- Get a Lower Interest Rate: The Fed may have lowered interest rates since you got your loan. You could have also improved your credit score during that time with on-time payments for your current loan. Getting a DSCR loan refinance can help you get a lower interest rate and reduce your monthly expenses.
- Extend the Loan: Adding more years to the backend of the loan reduces your monthly mortgage payments. This strategy increases your monthly cash flow, which can provide a margin of safety and give you more funds for your next down payment.
- Get Out of Debt Sooner: While this is a less popular strategy for rental property investors in growth mode, you can shorten your loan through a refinance to get out of debt sooner. However, shortening the loan will increase your monthly mortgage payments and lower your debt service coverage ratio. A lower DSCR can hurt your chances of getting this type of refinance, but it’s the road less traveled. Investors may have some wiggle room and can contribute to their mortgages with personal income and cash flow from other properties if they want to get out of debt sooner.
Is a DSCR Loan a Good Idea?
A DSCR loan is an unconventional mortgage that provides borrowers with more flexibility. Here are some of the reasons borrowers use DSCR loan programs to get financing for investment properties.
- No personal income requirement: If you do not have enough income to qualify for traditional financing, you can still get a rental property and generate cash flow from your assets. Even if you make good money, your debt-to-income ratio will increase as you take on more loans.
- Less paperwork: Since there are no income or DTI requirements, you have to submit less paperwork to get the loan. You don’t have to search for your tax returns, W-2 forms, or 1099s. This can save you a good amount of time and speed up the process of obtaining funds.
- You don’t get penalized for writing off taxes: Most financial institutions look at your taxable income to determine if you can afford the mortgage. However, real estate investors have many write-offs they use to preserve their wealth. While these strategies keep money in their pockets, each write-off reduces taxable income and makes them appear less desirable to conventional lenders. DSCR lenders ignore your taxable income, so those write-offs won’t hurt your application or result in lower interest rates.
- Fewer restrictions: Fannie Mae and Freddie Mac have more limits based on how much capital you can get for a loan, how many mortgages you can have at one time, and other restrictions. You won’t have to worry about those types of restrictions for DSCR loans. As long as you find properties with good DSCR ratios, you can continue acquiring properties and build your real estate portfolio faster.
What Are The Downsides of a DSCR Loan?
A debt service coverage ratio loan has several advantages. However, these mortgage loans are not perfect. Here are some concerns to keep in mind:
- Higher interest rates: These lenders don’t require any information about your personal income. If you can’t get a tenant on the property, you will have to use your personal income to cover the difference. Lenders increase their risk by not requesting this information, allowing them to charge higher rates than Fannie Mae and Freddie Mac.
- Higher down payments: Investment property loans help you use leverage to acquire more properties. However, you need to put at least 20% down to acquire the property. Investors may have to put more money down to reduce their debt service coverage ratios.
- You can’t use this loan for a flip or primary residence: DSCR lenders won’t let you go through the application process if you want a loan for a flip or primary residence. You have to buy a cash-flow-producing asset. It’s no problem if you want to buy rental properties and hold onto them for several years. However, other investors prefer to flip their way out of a property quickly or start and stop their investing journey with a primary residence.
You can get very deep into debt: DSCR lenders do not assess borrowers’ ability to make mortgage payments if properties become vacant. Investors with dozens of properties who rely on rental income can be in for a rude awakening if several of their tenants leave the property at the same time. Real estate investors should build large emergency funds with their rental income to mitigate this risk. Investors should determine how many rental properties they need to hit their goals and then focus on repaying debt before acquiring additional properties.
Do Banks Offer DSCR Loans?
Most DSCR loan programs are available through private lenders, like Angel Oak Mortgage Solutions. You can also consult with a mortgage broker to find other options that may be a good fit for you.
How to Get a DSCR Loan
A DSCR can help you acquire a real estate investment property. These insights can increase your chances of getting the best deal.
Understanding Eligibility Criteria of DSCR Loans
Lenders will look at a property’s ability to cover the total debt service. Financing companies will want a higher ratio so there is enough income coverage for maintenance costs and other expenses. A good credit score will help, but you won’t have to provide any income tax returns or personal income history. Make sure you check the specific criteria for each lender before applying. Lenders will also request an appraisal so they can see the property value.
Preparing for the DSCR Loan Program Application
Check the specific requirements for a DSCR loan program when submitting an application. You should also assess your finances and determine if you need a specific loan amount to proceed with the acquisition. Some borrowers have the flexibility to make higher down payments, while others have a hard limit.
You will have to gather documents like bank statements, appraisals, and leases for the property. This information can help a lender determine the potential income of the property.
Application Process for DSCR Loan
The application process for a DSCR loan program is straightforward. You don’t have to worry about lengthy approval processes that are more common with traditional loans. You can decide which loan terms you want, gather the necessary documents, and submit your application. The mortgage lender will contact you with a decision shortly after you apply.
What Loans Can You Get If You Have a Low DSCR?
If your DSCR is on the lower end, it will be hard to get a loan. Some lenders will work with you if your DSCR is 1.10, but you won’t get much luck with a DSCR under 1.0. An unfavorable DSCR will result in a quick rejection or a higher interest rate. Here are some other funding options to consider if the DSCR loan doesn’t work out.
Asset-Based Loans
As the name suggests, asset-based loans are granted based on the number of assets you have at your disposal. Like DSCR, tax returns aren’t required to prove your eligibility for a loan.
The Asset Qualifier Home Loan from Angel Oak Mortgage Solutions, a full-service mortgage lender, could be a viable option for you. Loan amounts of up to $3 million are available. To qualify, you’ll need at least $500,000 in assets post-closing, which could include stock, other investments, and funds in a checking account, savings account, or retirement account.
This loan product can be used to purchase a new property or to complete a rate-term or cash-out refinance. However, the property must be used as your primary residence. Furthermore, you’re not required to present income or employment information when you apply.
Bank Statement Loans
Bank statement loans are used by borrowers who prefer to provide personal or business bank statements in lieu of tax returns to substantiate their income.
Angel Oak Mortgage Solutions also features this loan product in its arsenal of mortgage offerings. Designed for self-employed borrowers with at least two years of experience, the Bank Statement Home Loan requires you to provide 12 or 24 months of personal or business bank statements when you apply. Or you can use 1099 income to qualify for a mortgage.
Your transactions are then analyzed to determine a loan amount that works best for your financial situation. For example, you could be eligible for a Bank Statement Home Loan between $150,000 and $3 million and use it to purchase a primary home, second home or investment property.
Hard Money Loans
While DSCR loan programs serve rental property investors, hard money loans are better for property flippers. These short-term loans have low down payment requirements and start off with low monthly payments. However, the expenses ramp up after the introductory period expires. Many flippers use this gap to renovate the property and list it on the market. In addition, hard money loans are nonconforming loans, which means fewer restrictions and higher loan amounts.
Explore Additional Mortgage Loans
If none of those options work for your financial needs, you could still be eligible for a mortgage. Another viable option for real estate investors is the Investor Cash Flow Loan. It also allows you to secure a mortgage of up to $1.5 million to purchase an investment property without providing tax returns or complex financial statements. Furthermore, there’s no limit on the number of properties you can purchase, and you’re allowed to place them in your LLC’s name.
You can complete this online form to learn more about other mortgage offerings available through Angel Oak Mortgage Solutions.
