Looking to grow your rental property portfolio, but keep getting turned down by traditional lenders? You’re probably wondering if DSCR loans are the key to unlocking your next investment.
Because these loans focus on property cash flow, not your personal income, they’re a popular alternative for self-employed investors, Airbnb hosts, and anyone building a real estate empire.
But are they the right fit for you?
This guide breaks down the pros and cons of DSCR loans to help you make an informed decision before applying for a real estate loan.
DSCR Loans: Quick Explanation
Before we get into the pros and cons of DSCR loans, let’s look at a quick definition.
iDebt Service Coverage Ratio (DSCR) loans are designed for real estate investors. They’re sometimes known as non-QM loans and are based on the income potential of your property. This is worked out using a Debt Service Coverage Ratio:
DSCR = net operating income ÷ total debt service
In other words, will the rental income generated by your property be enough to cover your debt obligations and property expenses?
While traditional lenders base their decisions on your income and debts, DSCR loan requirements are all about your rental property’s cash flow.
For a detailed explanation, take a look at our article on what DSCR loans are. Or, to quickly calculate different elements that could impact your rental property’s ROI, try our easy-to-use, free DSCR calculator.
The Advantages of DSCR Loans
Let’s look at the key benefits that make DSCR loans such an attractive financing option for those investing in income-producing properties.
1. Easier Qualification for Real Estate Investors
You don’t need to verify your finances through a W-2, employment history, or bank statements. DSCR loan requirements are based on a property’s rental income, which is why these loan types are so great for real estate investors.
Flexible Borrower Requirements
DSCR loans are suitable for various investors, including the self-employed, foreign nationals, and people with complex financial profiles. You can also apply for a DSCR loan as an individual or LLC.
3. Unlimited Property Financing Potential
DSCR loans aren’t a ‘one and done’ option. There’s no limit on the number of rental properties you can finance with them, so they’re ideal for growing your property portfolio quickly.
4. Qualification Based on Cash Flow
Cash flow is King for DSCR loans. Your personal income doesn’t factor into calculations, so even if you’ve had problems getting finance in the past, your property’s ability to generate income through monthly rents matters most.
5. No Debt-to-Income (DTI) Ratio Requirement
DSCR loans are different from traditional mortgages because they don’t require a specific DTI ratio. This flexibility makes it easier for investors with high leverage or debt levels to qualify. As long as your property is in positive cash flow, it’s likely you’ll be able to secure a loan agreement.
6. Options for Short-Term and Long-Term Rentals
You can use your DSCR loan for short-term vacation rentals, long-term rentals or a combination of both within your property portfolio. So, whether you’re looking to build an Airbnb empire or invest in multiple family homes, a DSCR loan could be ideal.
7. Higher Leverage Potential
The final benefit of DSCR loans is the availability of loan-to-value ratios of up to 75%-80%, which allows potential borrowers to add more properties to their portfolios with less upfront capital.
Potential Downsides of a DSCR Loan
DSCR loans do have disadvantages and aren’t the right fit for every real estate investor. Let’s explore some of these below.
1. Higher Interest Rates
There’s typically a price to pay for all the flexibility and advantages listed above. Choosing a DSCR over a conventional loan usually means paying higher interest rates. This is because of the higher perceived risk that comes from depending on rental income to make repayments.
2. Larger Down Payment Requirement
When applying for a DSCR loan, you’ll likely have to make a down payment of 20%-30% of the investment property’s value. This figure is higher than some other types of loans, so it’s important to be aware of it.
3. Stricter Ratio Requirements
To be eligible, your property needs to have a good potential operating income. It’s typical for money lenders to ask for a debt service coverage ratio of around 1.2-1.25 or higher. For example, if you have a property generating $2,000 per month in rental income and a total debt service of $1,600 per month, you’d have a DSCR of 1.25.
In simple terms, the lower your cash flow, the lower your chances of approval.
4. Possible Prepayment Penalties
Make sure you’re aware of all the conditions of your DSCR loan before going ahead. For example, you could be charged an early repayment penalty, and your refinancing options could be limited as a result.
5. Property Type Restrictions
Another disadvantage of a DSCR loan is that not every property type is eligible. For example, rural or unusual property types could be excluded. You also need to be aware that mixed-use, commercial properties and short-term rentals may have extra restrictions applied. This could negatively impact the rental income achieved.
6. Cash Reserve Requirements
In addition to needing a down payment of around 20%-30%, many DSCR lenders will ask for proof that you have 3-12 months of cash reserves to cover your monthly loan payments if tenants move out and you can’t find new ones. DSCR minimum loan amounts can vary by lender: at Express Capital Financing, we offer DSCR loans from $50 thousand to $3 million.
7. Less Favorable Terms for Lower Loan Ratios
If you have a rental property with a DSCR below 1.25, you may be charged higher interest rates on your DSCR loan and be asked to make a larger down payment. This could hit your forecast profitability when your loan terms are adjusted to match the perceived risk for lenders.
DSCR Loan Requirements: When Borrowing Makes Sense
Once you’ve weighed up all the pros and cons of DSCR loans, there are three main areas where these loans can fit the bill.
1. For Real Estate Portfolio Growth
When you’re looking to scale your rental property portfolio, you can finance multiple properties without having to factor in personal Debt-to-Income restrictions.
2. For Self-Employed Investors
You don’t need to jump through hoops to prove your income like with conventional loans. As long as your property has a debt service coverage ratio that meets the loan program terms, it doesn’t matter if you have a variable income.
3. For Short-Term Rentals
Any income from short-term vacation rentals through Airbnb and VRBO can be taken into account. This gives you the flexibility to capitalize on seasonal income.
What Are the Limitations of DSCR Loans?
As well as the pros and cons we discussed above, there are some other limitations for DSCR loans. In the following situations, it might be worth weighing up other loan options.
1. When Interest Rates Are High
High DSCR loan rates can reduce your profitability. When the Fed’s interest rate is low, comparing monthly repayment amounts with a more conventional loan could be worthwhile.
2. For First-Time Investors
The larger down payment and reserve requirements needed for a DSCR loan could be an issue. It might be worth looking at traditional loans until you’ve got more cash in the bank.
3. When Your Property Has Weak Cash Flow
The lower your rental income, the lower your debt service coverage ratio will be: making a loan denial more likely. While poor income potential can close the door on meeting DSCR loan requirements, there are other funding solutions for cash flow problems.
Time to Decide: Is a DSCR Loan the Right Fit?Â
Tailor-made for property investors, DSCR loans offer the flexibility, leverage, and opportunities essential for expanding your portfolio or venturing into new markets with short-term or long-term rental properties.
Eager to explore how DSCR loans can transform your investment strategy? Let’s discuss how a DSCR loan can work for you and unlock opportunities that traditional lending avenues may not offer. Don’t let funding hurdles hold you back any longer! Reach out to us now, and we’ll help you diversify your portfolio.
