New Financial Route

One of the problems real estate investors face when trying to scale their business is the limitations of conventional Fannie Mae mortgages, such as the limit of 10 conventional mortgages at a time or the need to have a W2 job to qualify. So what can you do if you just quit your job or cannot qualify for conventional financing for some other reason? DSCR loans are one of a few possible solutions that are commonly used by experienced investors.

What’s DSCR? And what’s a DSCR loan?

DSCR stands for Debt Service Coverage Ratio, which is just the ratio of the net income of a property and the debt service (i.e. the PITI payment of the loan — principal, insurance, taxes, interest)

DSCR = (Net Income)/(Debt Service)

For example, let’s say you own a property that you rent out for $1400 a month, with taxes and insurance at $200/month. The net income would be $1400 – $200 = $1200. If the mortgage payment is $800 a month, the DSCR ratio would be $1200/$800 = 1.5.

A DSCR loan is a loan that is based on the profitability of a rental property — measured by the DSCR ratio — in place of a borrower’s income. So when applying for a DSCR loan, the lender will not ask for pay stubs or W2s. In general, the underwriting process for DSCR loans is a lot faster and less beauracratic. However, DSCR lenders will take a closer look at the actual or potential cashflow of the property than those for conventional loans.

What are the requirements for a DSCR loan?

DSCR lenders typically like to see properties with a DSCR ratio of 1.1. One may think that a property with a DSCR ratio of 1 (breakeven) would be enough to quality for a loan, but there are other expenses involved with owning a property such as maintenance and property management. In other words, the property needs to have at least some cashflow.

Speaking of rental rates, many lenders will also require a submittal of rental leases so they can verify the property’s income. In some cases. a rental analysis if the property is not currently rented out.

For a new purchase, there is a requirement of a 20-25% down payment.

Speaking of requirements, what are some of the disadvantages of DSCR loans?

One of the main drawbacks of DSCR loans is the higher cost. These loans will typically about 1-2% higher than those of their conventional counterparts. There are additionally higher closing costs and origination fees.

DSCR loans also often come with prepayment penalties, oftentimes for complete loan payments done in under five years. This can become an issue if you plan or need to refinance (for example, if you want a loan with a lower interest rate).

These loans are only meant for purchasing investment properties, which means that you won’t be able to live in any property that is financed using A DSCR loan. This can be an issue specifically for those who are looking to make a property a primary residence and investment property through house-hacking (living in a house of small family and renting out rooms or other units).

Are DSCR loans right for me?

Overall, DSCR loans are great for investors who are looking to scale their businesses quickly without the restrictions and lengthy process of conventional financing. These loans are a perfect option for those who are refinancing from an expensive hard money loan into a relatively more affordable long-term mortgage.

Personally, I’ll be using a DSCR loan for my triplex after I’m done renovating it. There are many lenders that have loan programs that are designed specifically for investors to get hard money loans and refinance into DSCR within a year.

If you’re just starting out and don’t own many properties, conventional loans will probably be your best bet. The financing will be cheaper, especially if you are planning to live in the property yourself. And while there is a requirement for an owner to live in an owner-occupied property for at least a year, you can move out after the 12-month period and rent it as you like.

It’s worth noting that while you don’t need a steady income to purchase a rental property, it’s important to have an emergency fund and reserves to deal with unexpected surprises.