What is a DSCR loan? And Why should you care?

Stop me if you have heard this story before…. I would like to purchase a Short-Term Rental property but I am reaching the top of my DTI (Debt-to-Income) ratio so I might not qualify.

This might be a scenario you are experiencing with your first STR but it is more likely a situation that you’ll experience when growing your STR portfolio.

As your portfolio grows you will need to answer a few questions…

Do you stop investing because qualifying for traditional financing is more difficult? 

Are there alternatives to the traditional mortgages?

Should you consider investing by taking debt above your DTI?

These are all valuable and important questions to consider.

First, there are alternatives to traditional mortgages and these are called Debt Service Coverage Ratio loans/mortgages. 

These loans are different than your traditional mortgage because the underwriting for these financial products is based on the income of the property covering the debt.

The calculation is performed as follows: 

The NOI (Net Operating Income)  divided by the debt service.

For example: 

If the NOI is 100k and the Debt service is 70k then the DSCR is (100/70) = 1.42

A value of 1 is breaking even

Less than 1 results in a default (the cost of the debt service is greater than the NOI

But a value of 1.25 or higher indicates a strong DSCR.

The higher the ratio the less risky the investment.

With this knowledge you can see the benefit of a DSCR loan.

The main benefit of a DSCR loan is that underwriting is NOT based on your personal income covering the debt. 

As demonstrated above this is based on the ability of the income from the property to cover the debt for the property.

Therefore, your personal DTI (Debt to Income) ratio does not influence your ability to qualify for these loans.

Other benefits of DSCR loans include:

  1. Purchasing directly into an LLC.  (You cannot do this with a 10% down second home loan).
  2. Faster closing times
  3. No limit to the number of loans

The Downsides:

  1.  Often requires a higher down (15-20%) when compared to a 10% second home loan.
  2. Interest rates will be higher than a second home loan.
  3. Many of these products carry a repayment penalty.
  4. Need to provide proof of experiencing renting (STR or LTR)

There are many benefits to this product and utilizing this form of financing can help you grow quickly as long as you have enough capital to cover down payments and maintain cash reserves.

The downside of this strategy is that it allows you to leverage past your DTI. This puts you at increased risk of being unable to cover your debts… This is also the benefit of this product in that it allows you to borrow above and beyond your DTI ratio.

The trick is for you to decide if this option is “good” or “bad” for you. Personally, these products, in this environment, make me slightly concerned and I conjure up some flashbacks to 2008.

The difference today is that you need a significant down payment to qualify for a  DSCR product… but the lack of qualifying income and repayment penalties make me slightly concerned…

What happens if the market turns and the average buyer does not have reserves and needs to sell? 

You will not be one of those statistics because you are reading this blog and will maintain reserves combined with a buy and hold strategy.

With that said, if you use the DSCR product wisely while maintaining cash reserves this can be a great product. 

However, if you are not maintaining reserves while expanding rapidly you may increase your risk of default and this is the part that makes me concerned about the changing financial landscape at the time.

Click here to read more about DSCR loans

Enjoy your Journey to Financial Freedom

3 thoughts on “What is a DSCR loan? And Why should you care?”

Leave a Reply

Your email address will not be published. Required fields are marked *