If you want to finance the purchase of a rental, multi-family, or commercial property, there are many loan choices to pick from. One worthy option is a DSCR loan, which looks closely at your future rental and earnings income to underwrite the loan and doesn’t require personal earnings to qualify. A DSCR loan can also close more quickly than other types of loans.
Find out how a DSCR works, how to qualify, the terms and costs involved, and different DSCR lenders to consider who offer this type of financing.
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DSCR Loan: What It Is and How It Works
A DSCR loan stands for a “Debt Service Coverage Ratio” loan. This financing option is often used for income-producing commercial properties like apartment buildings and shopping centers. This non-qualified mortgage (QM) loan is popular among real estate investors because it does not require the borrower to verify their income. Instead, the lender uses the property's cash flow to determine the borrower's ability to repay the loan.
The lender calculates the Debt Service Coverage Ratio to review the cash flow generated by the property/asset and determine if it is sufficient to cover the loan payments. This means that borrowers with lower or unverifiable income streams may still qualify for a DSCR loan if the asset's cash flow meets the lender's criteria.
To determine the DSCR number, the lender will divide the property’s net operating income by its annual debt service. Commonly, the lender will take the lower of the rent schedule/lease agreement and divide it by the PITIA payment – which stands for principal, interest, taxes, insurance, and association dues, explains Steve Silver, originator/manager of Silver Mortgage Company in Houston.
Often, the lender requires a minimum DSCR of 1.20 to 1.35. In other words, the property's net operating income should be 1.2 to 1.35 times the annual loan payments.
Pros and Cons of DSCR Loans
DSCR loan advantages include:
- They may come with a lower interest rate than other types of commercial real estate loans. This is because DSCR loans are secured by the property and the borrower's cash flow. “Borrowers who can demonstrate a higher DSCR ratio may be able to secure better rates and terms,” says Jon Christensen, CEO of Bidmii International, Inc. “Rates can be fixed or variable.”
- Some DSCR loans may also provide flexible repayment options such as interest-only payments or a balloon payment at the end of the loan term, which can help borrowers manage their cash flow.
- Borrowing limits can be generous. “You may be able to borrow from $100,000 to $5 million or more, depending on the lender,” Christensen says.
- Quicker closing time than many other types of loans.
Drawbacks of DSCR loans include:
- They often have stricter underwriting standards compared to other types of commercial real estate loans since they are based on the borrower's ability to generate sufficient cash flow to cover the loan payments. This means that borrowers with weaker financials may not qualify.
- DSCR loans may also require higher upfront costs, such as a larger down payment or higher closing costs, which can make them less appealing to borrowers looking to minimize their upfront expenses.
- They may have higher prepayment penalties than other types of commercial real estate loans, which can make it challenging for borrowers to refinance or sell their properties in the future.
- DSCR loans are secured by the property itself, which means that the lender has a lien on the property and can foreclose on it if the borrower defaults on the loan.
Good Candidates for a DSCR Loan
“DSCR loans are primarily used by real estate investors. While some businesses may use these loans to purchase storefronts, office space, or industrial space to use themselves, the vast majority of DSCR borrowers make their money by purchasing properties and renting them out to tenants, whether residential or commercial,” adds Ang.
Worthy prospects for a DSCR loan include those who want to keep their business financials separate from their personal finances, investors who want to avoid providing personal income information or debt-to-income ratios, those who don’t plan to live in the property as a primary residence, and borrowers who can afford a down payment of at least 20% of their own funds (as no gift funds are allowed with a DSCR loan).
“This loan is also ideal for investors who want the property title to be in the name of an LLC, and investors and owners who own or want to purchase multiple properties – as loan approval here doesn’t limit the number of units owned,” Silver notes.
DSCR Loan Qualifications
Because a DSCR loan is not a conforming loan product or insured by the government, there aren’t uniform lending guidelines that lenders follow. But a DSCR lender will likely require that you meet the following criteria to qualify for this loan, per Silver:
- Credit score of 640 or higher
- Down payment minimum of 20%-25%; a DSCR ratio of below 1.25 will probably require a bigger down payment
- Property must be income-generating
- DSCR ratio should be above 1.0; many lenders require the ratio to be at least 1.20 to 1.35
“Fortunately, because a DSCR loan doesn’t factor in your income or liabilities, your debt-to-income ratio is not used,” adds Silver.
DSCR Loan Costs
What you will pay in total loan costs for a DSCR loan will vary, depending on the lender, loan rate and terms, and your ability to qualify.
“Often, fixed mortgage rates for a DSCR loan today can range from 8.75% to 10.25%, or higher if you have a lower credit score,” says Silver. “In general, the fixed rate for a DSCR loan can be around 2% to 4% higher than for a typical conforming mortgage loan interest rate.”
You’ll also have to pay closing costs with a DSCR loan, which could range from 2% to 5% of the total loan amount. Case in point: If you secure a $1 million DSCR loan, you expect to pay anywhere from $20,000 to $50,000 in closing costs. Closing expenses can include loan origination fees, appraisal fees, title search and insurance fees, legal fees, and other miscellaneous costs.
DSCR Loan Terms
DSCR loans often have longer loan terms, which can be beneficial for borrowers who want to reduce their monthly payments. The experts say you can choose anywhere from a 5-year loan to a 40-year loan, although most DSCR loans last 30 or 15 years – similar to a primary mortgage loan.
DSCR Lenders
Commercial lenders, such as banks, credit unions, and private lenders, are the primary sources of DSCR loans. These lenders have expertise in commercial real estate lending and often have specific criteria that borrowers must meet, such as minimum credit scores, cash reserves, and experience in managing income-generating properties.
Popular providers of DSCR loans today include:
- Beeline
- New Silver
- Griffin Funding
- Truss Financial Group
- North American Savings Bank
- Kiavi
- Lima One Capital
- Angel Oak
You can also pursue alternative lenders and online platforms that offer DSCR loans, which can provide more lenient underwriting standards and quicker approval processes. But these lenders may charge higher interest rates and fees compared to other commercial lenders.
The Bottom Line
DSCR loans can be a valuable financing option if you are seeking to purchase an income-generating property. Just be sure to shop around thoroughly among several different lenders and DSCR loan offers and carefully compare interest rates, terms, fees, and requirements. And kick the tires on alternative forms of financing, too.
