What Is a DSCR Loan, and How Does It Work?

If you’re a real estate investor exploring your financing options, you’ve probably encountered the term “debt service coverage ratio,” or DSCR.

These specialized loans allow real estate investors to finance income-generating commercial and rental properties based on the property’s cash flow — rather than their personal income and creditworthiness.

But what is a DSCR loan exactly, and how do they work? What kinds of properties are eligible for debt service coverage ratio loans? What are the benefits and drawbacks of this unique financing strategy?

Those are just a few of the frequently asked questions we will address in this article.

What is a DSCR loan?

A debt service coverage ratio (DSCR) loan is a type of loan that’s based on the income generated by the rental or investment property being financed, instead of personal income.

A traditional mortgage loan, on the other hand, is typically based on the borrower’s credit score, income, and personal debt situation. But with a DSCR loan, lenders are mostly concerned with the income and debts associated with the investment property being purchased.

How is the debt service coverage ratio calculated?

To calculate a DSCR, lenders will divide the net operating income (NOI) of the property by the debt service (principal and interest payments) on the loan. In other words, the debt service coverage ratio is calculated by dividing the rental income by the monthly payments associated with the property.

For example, if a property has an NOI of $10,000 per month and a total debt service of $5,000 per month, the DSCR would be 2.0. Because 10,000 divided by 5,000 equals 2.

A DSCR of 1.25 or higher is generally considered to be a good indication that the borrower will be able to repay the loan. It shows that the property generates enough income to cover the loan payments, while also leaving a margin of safety for the borrower. But this type of analysis can vary from one lender to the next.

What types of borrowers use these loans?

DSCR loans are typically used by borrowers who have difficulty qualifying for traditional loans, for a variety of reasons. They tend to be most popular among borrowers with:

• Self-employment income
• Multiple mortgaged properties
• Less-than-stellar credit
• Insufficient collateral

DSCR loans are also a good option for borrowers who want to purchase an investment property based on the merit of the rental, rather than their own income.

What types of properties are eligible?

Debt service coverage ratio loans are typically used to finance income-producing commercial properties. This can include apartment buildings, office buildings, retail centers, warehouses, and industrial properties. Properties ranging from 1 to 8 units are typically acceptable, but this can vary.

These properties are typically purchased by investors and businesses with the intention of generating rental income or operating income from the property.

When it comes to DSCR loans, property eligibility can depend on a variety of other factors. This includes the property’s location, condition, type, and size. The lender will also consider the property’s cash flow and net operating income (NOI), as mentioned above. In some cases, they might also look at the borrower’s creditworthiness.

As with other aspects of the DSCR loan, the specific types of properties that are eligible can vary from lender to lender. However, most lenders will require that the property be in good condition and that it meets applicable zoning and building codes, at a minimum.

What are the benefits of a DSCR loan?

Debt service coverage ratio financing offers several benefits:

• Easier qualification: DSCR loans are typically easier to qualify for than traditional loans, as lenders do not need to verify the borrower’s personal income.
• More flexible terms: This type of financing can offer more flexible terms, when compared to traditional property loans. This might include longer repayment terms and lower interest rates.
• Access to capital: DSCR loans can provide investors with access to capital they might not be able to obtain through other means.

What are the basic requirements?

The requirements for a DSCR loan will vary from lender to lender, but some common requirements include:

• A minimum debt service coverage ratio (DSCR): As mentioned above, a DSCR of 1.25 or higher is generally considered to be a good indication that the borrower will be able to repay the loan.
• A minimum credit score: Generally speaking, lenders will typically require a minimum credit score of 620 or higher for a DSCR loan.
• A down payment: A down payment is typically required for a DSCR loan, although the amount will vary from lender to lender.
• Property appraisal: The property will probably have to be appraised at a value that’s sufficient to secure the loan.

Are there any drawbacks or disadvantages?

As with any type of loan, there are some potential downsides associated with DSCR loans. So you’ll have to weigh the pros and cons to determine if it’s the right financing strategy for you.

Potential drawbacks for debt service coverage ratio loans:

• Higher interest rates: DSCR loans often have higher interest rates than traditional loans, as lenders are taking on more risk. When it comes to property lending, anything that increases the level of risk also increases the interest rate.
• Prepayment penalties: DSCR loans may have prepayment penalties, which can be costly if the borrower needs to pay off the loan early.
• Loss of income: If the property’s income declines, the borrower may not be able to make the loan payments, which could lead to foreclosure.

Ready to explore your options?

Bridgepoint Funding is able to provide debt service coverage ratio loans in most states across the U.S. We work with a number of different lenders, which gives us the ability to match the right product to each individual client.

If you have questions about using a DSCR loan to purchase a rental or investment property, please contact our knowledgeable staff. We look forward to helping you!