As a real estate investor (or future investor), you know the potential rental income that a property can bring. But as you keep adding to your real estate portfolio, it can be more challenging to secure financing.
There are, however, a few options you may want to investigate, including both debt service coverage ratio (DSCR) loans and conventional loans. But which one should you choose? Learn more about each option and their differences to determine what could be right for your needs.
What’s a DSCR Loan?
A DSCR loan or debt service coverage ratio loan is a type of financing that helps borrowers qualify with their DSCR instead of their personal income. Your debt service coverage ratio measures the potential cash flow of a property versus its ability to generate enough income to pay back the debt. The formula used to review for DSCR is as follows:
DSCR = Net Operating Income / Total Debt Service
Net Operating Income = Revenue – Certain Operating Expenses
In most cases, a “good” DSCR is at or above 1.25, which means the property can pay back its debt 1.25 times over.
Since DSCR loans place more importance on the property’s DSCR rather than your personal income, it may be easier to qualify for them. This could help speed up the process since your lender won’t have to take a deep dive into your finances or creditworthiness. Because DSCR loans don’t adhere to the same guidelines as other loans, you may be able to be approved even if you weren’t previously approved for a traditional mortgage.
However, you should keep in mind that DSCR loans typically require more cash upfront than other types of loans and they can only be used for investment properties.
What’s a Conventional Loan?
In layman’s terms, conventional loans are loans that aren’t insured by the government, and they’re often what potential borrowers think about when they need to obtain a mortgage. Since they’re not secured by the government, they’re usually offered through private lenders or the government-sponsored enterprises (GSEs), Fannie Mae® and Freddie Mac®, and may have stricter requirements than other types of loans.
While it can be more difficult to qualify for a conventional loan, they come in different types and different terms. For example, you can get either a fixed-rate or adjustable-rate mortgage (ARM), conforming or non-conforming loans and more.
Conventional loans can be used for both residential homes and investment properties, but you may need a larger down payment and more money in reserve for investment properties. However, conventional loans typically have lower interest rates than DSCR loans.
The Differences
There are some key differences between DSCR loans and conventional loans.
Property Type
DSCR loans are only available for investment properties while conventional loans have a variety of purposes for both investment properties and residential homes including purchases and refinances.
Loan Terms
Typically, DSCR loan terms are aligned with the financial performance of the property, so the loan may better accommodate cash flow cycles or other considerations unique to investment properties. On the other hand, conventional loans adhere to the structures of fixed-rate and adjustable-rate terms.
Income Requirements
When you apply for a DSCR loan, your lender would place more importance on the property’s income potential (or DSCR) than your personal income. Conversely, if you apply for a conventional loan your lender will place more importance on your personal income to determine if you’re eligible.
Which Loan is Right for You?
It simply depends on your personal needs, goals and financial circumstances.
If your personal income and credit score don’t meet the minimum requirements for a traditional mortgage, you may want to consider a DSCR loan. Since they’d qualify you based on your DSCR more than your personal income and if you know this property could perform well, you may have more of a chance of being eligible for a DSCR loan. Additionally, if you’re on a strict timeline, a DSCR loan may be faster than a conventional loan since they wouldn’t have to dig into your personal finances.
However, if you do have a “good” credit score, you may want to consider applying for a conventional loan since they typically have more favorable interest rates than DSCR loans. In addition, if you want to buy a building outside of a rental property, like a single residential property, a conventional loan could work for you. Keep in mind that you cannot finance multiple rental properties at one time with conventional loans, but you can with a DSCR loan.
Work with an Investment Property Financing Professional
DSCR loans and conventional loans are both common choices when you’re buying investment properties. However, choosing one or the other is different for different real estate investors. As you educate yourself on the options out there, make sure you work with a reputable lender who is experienced in financing investment properties and who can guide you to a solution that will work for your needs.
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.
