DSCR loans are getting more popular now. You’d think they were just invented. They have been around for a long time, just not with that name. This is just a type of loan that underwriting relies on the strength of the deal rather than the strength of the borrower. Let’s dig in.
What Does DSCR Mean?
Remember from my previous post that DSCR stands for Debt Service Coverage Ratio. If you don’t remember, it’s important you click the link to read up before going on with this post. Basically, it is the multiple of your NOI to the Debt Service (the mortgage payments). It represents to the bank how likely their money will be paid back, even if times get lean. The higher the ratio, the more money is brought in relative to the debt, and the more likely it is you will be able to pay it.
What is a DSCR Loan?
First, you should ask what is not a DSCR Loan. These other loan types are broadly, unsecured loans – much like your credit card – they can’t take your house or car if you don’t pay them back, and conventional mortgages. Conventional mortgages are underwritten (evaluated for fitness to make the loan) based on the borrower’s ability to pay the mortgage back. They look at the strength of the borrower’s financials. These are great for those of us high performers buying small to medium properties. We will theoretically be able to pay the loan even if the property makes $0. Banks like these because they have a ‘backup’ if the investment fails for some reason: they can go after the borrower personally. This is called a loan guarantee.
The DSCR loan only looks at the financials of the project. The bank, in this case, will look at the expected ability of the property to pay the mortgage in a variety of market conditions. Consider an 8-plex that has an NOI of $20,000 a year. If the debt service is $15,000 a year, then the DSCR is 1.33. That means there is $5,000 left over (the cash flow) that can be used to maintain the property or saved for difficult times. If the NOI of the same property is $16,000, an investor might think this is great because there’s still cash flow. The bank views this as a DSCR of 1.07. This loan isn’t going to be offered.
Benefits of the DSCR Loan
- You don’t have to have great personal financials
- The bank will rely more on the numbers and not you as a person
- You don’t personally guarantee the loan (easier to walk away from a bad project, but don’t ever do this)
Downsides of the DSCR Loan
- Harder to find banks willing to offer this type of loan
- Fees will be higher
- You need to have your deal’s financials in good order before applying
- Your deal will need to have a higher NOI than it would with another type of loan. This limits the deal pool from which you can choose
For high performers, I recommend going with the conventional loan. You don’t really need the benefits of the DSCR. You’ll have an easier time and pay less money with conventional.
