Taking the first step to buying an investment property includes understanding how you’re going to buy it. While traditional mortgages are an option you can look into, there is another type of financing that may work specifically for your investment property: debt service coverage ratio (DSCR) loans.
When you’re investing in real estate, it’s imperative to understand all your financing options to ensure you get the loan that works for you and your financial goals. That includes learning about the loans you may not have previously been privy to. Take a look at the details of DSCR loans, how they work and some of their benefits and drawbacks to find out if you could take advantage of one for your growing real estate portfolio.
What is a DSCR?
To first understand DSCR loans, you must learn about your debt service coverage ratio. The DSCR refers to your property’s potential cash flow versus your ability to pay back debt. This ratio is measured with a formula that divides your net operating income by your total debt service. Your net operating income is your revenue minus any certain operating expenses.
Formula:
DSCR = Net Operating Income / Total Debt Service
Net Operating Income = Revenue – Certain Operating Expenses
Typically, if your DSCR is at or above 1.25, it’s a strong indicator that the property can reliably pay back its debt. So, as you’re looking at DSCR loans for your investment property, you may want to consider estimating your own DSCR to see if this type of loan could work for your personal situation. And if you’re not confident about your math, it doesn’t hurt to speak with a professional lender or financial advisor before you start the loan process.
How Do DSCR Loans Work?
A lender will look at your income no matter what loan you get. But with a DSCR loan, they’ll look at the potential income of your investment property using the formula above to determine your ability to pay back the loan. Less importance is put on your personal income or creditworthiness, so the loan amount you may be approved for is highly determined by your DSCR.
This could potentially be a significant advantage for you, especially if you’re looking to get financing faster than a traditional mortgage or you previously haven’t been able to qualify for a traditional mortgage for your investment property.
Pros and Cons
Pros
The main advantage to getting a DSCR loan is that lenders will focus on your investment property’s potential income and not your personal income. This can help speed up the loan process since your lender won’t have to take a deep dive into your income streams or creditworthiness which could help you get to closing day sooner than other loan types.
Using your investment property’s DSCR to qualify for a loan may also help you get the financing you need but can’t get with other traditional loans. Because DSCR loans have different guidelines from other types of loans, lenders may be able to approve you even if you have not previously qualified for a traditional mortgage.
Cons
If you’re considering a DSCR loan, you may need more cash upfront than with other types of loans. Typically, a lender will want you to have a certain amount of cash reserves and a higher down payment than an FHA loan, for example.
In addition, DSCR loans can only be used for specific properties, and you cannot live in the property. These types of loans are meant for investment properties only.
When Should You get a DSCR Loan?
If you’re self-employed, you may already know that qualifying for a traditional mortgage has its challenges. So, a DSCR loan might help make the process on an investment property a bit easier since lenders won’t necessarily need to look at proof of consistent personal income. If you show a lender that your investment property can reel in a sufficient cash flow, a DSCR loan could work for you.
In addition, some lenders won’t approve you for a new loan if you have multiple mortgages already, even if your investment property has the potential to generate enough income to cover a new mortgage. However, lenders who offer DSCR loans are more likely to see your real estate investments as assets than a risk.
All in all, whether you’re a first-time investor or currently own multiple investment properties, a DSCR loan could work for either type of borrower. It just depends on your personal situation and financial goals.
Your Financing Options for Investment Properties
Knowing what your loan options are as an investor is essential as you take on a new property, no matter if it’s your first or tenth. And a DSCR loan is a great financing option if you’re confident about the property’s potential income. Even if you’re not sure, an experienced and reputable lender will advise you about all your options to help you feel confident in your decision.
This article is intended for general informational and educational purposes only and should not be construed as financial or tax advice. For more information on financial planning or investment advice, consult a registered investment advisor or financial planner.
This information is intended for educational purposes only. Products and interest rates subject to change without notice. Loan products are subject to credit approval and include terms and conditions, fees and other costs. Terms and conditions may apply. Property insurance is required on all loans secured by property. VA loan products are subject to VA eligibility requirements. Adjustable Rate Mortgage (ARM) interest rates and monthly payment are subject to adjustment. Upon submission of a full application, a mortgage banker will review and provide you with the terms, conditions, disclosures, and additional details on the interest rates that apply to your individual situation.
