A mortgage for real estate investors: the DSCR loan
Financing a rental property can be a real Catch-22.
To get approved for a traditional mortgage, you may need to count the rental income you’ll be earning from the new property. Yet you often can’t document this rental income until after closing on the loan and collecting rent.
Or, if the lender allows you to count proposed rent, you may not be able to document enough personal income to qualify via tax returns and other income paperwork.
If you face this sort of dilemma, a Debt Service Coverage Ratio (DSCR) loan may be the answer. DSCR loans base your loan eligibility, in part, on the rental home’s potential to earn income in the future.
What’s in this article?
Traditional mortgage lenders can’t use your future rental income because they look to the past to gauge your earning power. From their point of view, your income over the past two years predicts how much you’ll earn next year and the year after that.
As a result, your eligibility for a new mortgage — and the maximum size of the mortgage loan — depends on your recent tax returns, W2s, 1099s, pay stubs, or bank deposits. If those recent earnings aren’t high enough to support your new mortgage along with your existing debts, you won’t get approved.
When you apply for a DSCR loan, underwriters can look forward. They measure the potential earning power of the property you’re buying. Then they can use that potential income to help approve financing.
A property that brings in $1,500 per month with a payment of $1,100, the income services the debt, and the buyers’ personal income documentation may not be required.
For instance, a property that brings in $1,500 per month with a payment of $1,100, the income services the debt, and the buyers’ personal income documentation may not be required.
This strategy can help would-be investors buy rental properties sooner by eliminating the need to file two years’ tax returns showing adequate income before financing a rental property. Rather than waiting until you have the debt-to-income ratio required to get a traditional mortgage approved by rules set by Fannie Mae or Freddie Mac, you can get financing now based on the rent you’ll earn from the new property.
DSCR loans can also help borrowers who have a hard time documenting their existing income because they’re self-employed or because they rely on investments for part of their income.
DSCR stands for debt service conversion ratio. The amount of debt a lender will underwrite depends, in part, on how much your new property could earn from rent.
But there’s more to qualifying than simply finding a property for sale that has the potential to earn rental income. Here are some DSCR loan requirements to be aware of:
Debt service coverage ratio minimum
Most lenders look for a debt service coverage ratio of 1.25, meaning the property earns 25% more than its all-inclusive payment.
For instance, a property with $1,250 in monthly rental income could have a total payment including principal, interest, taxes, insurance, and HOA dues of $1,000.
Some lenders allow a DSCR of just 1.0 or even 0.75, but they may require personal income verification to qualify.
Many DSCR lenders will accept loan-to-value ratios as high as 80 percent. Others will finance up to 75 percent of the rental home’s value.
This means you’d need to provide the other 20 to 25 percent of the purchase price as a down payment.
DSCR credit score requirements tend to run a little higher than conventional loan guidelines. For a DSCR loan, you’d need a FICO score of at least 640 with most lenders.
With some lenders, a higher LTV — think 75 to 80 percent — may require higher credit scores such as 660 or 720.
DSCR loans are designed for buying investment properties. Individuals and LLCs, along with businesses and commercial real estate developers, can use DSCR loans.
You could use a DSCR loan to finance most type of rental properties, including vacation homes and properties that you’ll lease to residential tenants. These loans can finance single-family homes, duplexes, triplexes and four-plexes.
Unlike conventional lending, DSCR loans can also finance properties with more than four units.
Property bought with DSCR financing must be used to earn income from rent, whether it’s residential or commercial real estate.
Lenders offer fixed-rate as well as adjustable-rate options for DSCR loans. Terms could stretch to 40 years, though most lenders offer up to 30-year DSCR loans. Some lenders offer interest-only payment structures.
DSCR loan providers will not measure your personal income, check your W2s or 1099s from work, or measure your debt-to-income ratio. Instead, they’ll consider the potential earning power of your new rental property.
That’s why some lenders call these no-income verification investor loans.
You could find DSCR loan amounts as high as $5 million. Most lenders cap loan amounts at $1 million or $2 million.
These kinds of maximums don’t mean you’ll automatically get a loan that large. Your maximum loan size will depend on your property’s debt service coverage ratio.
Unlike government-insured home loans, DSCR loans won’t limit the number of properties you can finance at once. This is possible because lenders use the property you’re buying — more than your personal credentials — to underwrite the loan.
Lenders can charge prepayment penalties on DSCR loans. These loans are not covered by federal laws that protect consumers from these penalties.
Eligibility for borrowers with negative credit events like bankruptcy and foreclosure will depend on the lender. But if you have a recent bankruptcy or foreclosure, you likely won’t meet the 640 minimum credit score requirement. If you have a high enough score, check with your lender on their specific recent credit event guidelines.
DSCR-financed rental properties can be closed in the name of your limited liability companies, or LLCs.
Some lenders may cap seller concessions at 2 percent of the loan amount. If you plan to negotiate with the seller to pay some or all of the closing costs, check with your lender first.
DSCR loans work well for property investors who want to keep their real estate holdings separate from their personal finances. These loans use income generated by the property you’re buying — rather than your personal income from work — to qualify for the loan.
Borrower credentials matter some, too. Applicants need credit scores of 640 or higher and the ability to put at least 20 percent down on the property.
Since these are non-QM loans — meaning they’re not backed by a federal agency or Fannie Mae and Freddie Mac — expect to pay higher interest rates.
Along with making a down payment of 20 to 25 percent and having a credit score of 640 or higher, you’ll need to meet your lender’s DSCR requirement. Some lenders may require your property to earn 150% of the home’s monthly mortgage payment. That would be a DSCR of 1.5.
DSCR requirements vary by lender and borrower. A loan whose payment matches the rent payment on the home would have a debt service conversion ratio of 1.0. Lenders usually require a ratio between 1.0 and 1.5.
No, a DSCR loan can offer long-term financing, just like a conventional mortgage loan.
No, DSCR underwriting relies mostly on income generated by the rental property you’re financing. Your personal finances will face less scrutiny than they would for a traditional home loan.
DSCR loan: a solution for the beginning or seasoned real estate investor
You don’t have to be a millionaire or an established real estate developer to buy a rental property with a DSCR loan.
Rather than leveraging your personal finances to get the loan, you’ll be leveraging the earning potential of the home you’re buying.
This kind of loan may be just what you need to launch, or grow, your very own real estate portfolio.