What is a DSCR loan? A complete guide

Investing in rental real estate is a time-tested strategy that millions of Americans have used to build wealth over time. In order to earn rental income, however, you first have to buy a property, and that can be expensive. There are many ways to finance real estate investments, but an often overlooked strategy is a DSCR loan. 

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Lenders make underwriting decisions for a DSCR loan based on the income potential for your property, rather than your own personal income. If you're self-employed or otherwise unable to qualify for more traditional mortgages, you may want to consider a DSCR loan. We’ll dive more into the DSCR loan, meaning – how they work, who they’re right for, and what to consider. 

What is a DSCR loan?

A DSCR loan is used by individual investors to buy residential homes as a real estate investment to generate rental income. Investors turn to DSCR loans for several reasons, often because it’s easier to qualify if you face income limitations. 

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Lenders always look to vet your income when you borrow money to buy real estate because they want to ensure you’re able to repay the loan. Many individual real estate investors rely on conventional mortgages to buy rental properties—at least to start—and in these cases, lenders will assess your personal income when deciding whether to approve you for a loan. It can be hard to get approved once you have several leveraged properties under your belt, or if you’re self-employed.

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DSCR loans make it easier to get approved in these cases. Rather than evaluating your personal income, a lender will look at the income potential for the property you’re buying. Your own personal finances don’t matter as much as the property itself; if it has strong income-generating potential, then you’re more likely to get approved.

Understanding debt service coverage ratio (DSCR)

The acronym DSCR refers to “Debt Service Coverage Ratio,” a measure of the cash-flow potential of the property. It’s calculated like this: 

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Debt Service Coverage Ratio = Net Operating Income / Monthly Loan Payment (PITI)

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In this calculation, “net operating income” refers to how much you’d be earning in rent each month, minus overhead expenses such as holdbacks for repairs and maintenance, property management fees, etc. Your monthly loan payment would be calculated similarly to your mortgage: Principal + Interest + Taxes + Insurance (plus any HOA fees, if applicable).

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Most lenders look for a DSCR ratio of 1.2 or more, indicating that your income is higher than your expenses. If your DSCR ratio was 1.0, your income would exactly equal your debt obligations; anything below 1.0, and you wouldn’t be earning enough each month to cover your mortgage payment. 

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For example, if you earn $2,000 per month after expenses and your mortgage payment is $1,500, your DSCR ratio would equal 1.3. If your mortgage costs $2,100 per month, however, your DSCR ratio would be 0.95; your rental income wouldn’t even cover your mortgage, and it’s unlikely any lender would approve you for a DSCR loan. 

How the DSCR ratio differs from other loan metrics

Most people are more familiar with the DTI (debt-to-income) ratio that lenders use when evaluating you for a regular mortgage. The DSCR ratio measures the same thing, but in reverse: it’s your income-to-debt ratio. This shifts the focus more onto the income side of the equation since DSCR loans are meant for income-generating investments.

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You may also come across the term “LTV” or “loan-to-value” ratio, which measures the size of the loan relative to how much the property is actually worth. Lenders use the LTV ratio in underwriting both regular mortgages and DSCR loans. It’s a way to measure the riskiness of the loan since borrowers with larger debts (relative to the property’s actual value) are more likely to default on the loan in the long run – and if they do, the lender could lose money.  

DSCR loan requirements

Most of the common mortgage types have strict qualification requirements dictated by government programs; DSCR loans, on the other hand, aren’t bound by these ironclad rules. Thus, lenders are much more free to determine their own qualifications for the DSCR loans they offer, and these can vary quite a bit between banks. Here’s a typical set of requirements for a DSCR loan:

• LTV ratio: 80% or less
• Loan use: 1-4 unit residential properties, non-owner-occupied
• Credit score: 680 or higher
• Loan amount: $175,000 or more
• Investor experience: Stricter eligibility criteria for new, inexperienced investors

Pros and cons of DSCR loans

Here are the biggest factors to consider when deciding whether a DSCR loan is right for your investment financing needs:

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Pros:

• Fast funding: Since lenders don’t need to do a thorough investigation of your personal finances, DSCR loans are often quicker to get than conventional mortgages. 
• Diverse loan options: DSCR loans can be used to purchase or refinance properties with fixed or variable rates, access equity through cash-out refinances, and can even be structured with interest-only payments for a portion of the loan.
• Flexible underwriting: Lenders aren’t bound by strict guidelines like with other mortgages, allowing them more freedom to approve borrowers who may not otherwise qualify.

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Cons: 

• Cash reserves required: Most lenders will require you to have three to six months of reserves in a savings account in case you run into vacancy issues or other problems. 
• Down payment required: Getting a DSCR loan with no down payment isn’t generally possible unlike some mortgages; most lenders will require at least 15% to 25% down. 
• No owner-occupied financing: DSCR loans are meant exclusively for investment purposes only; unlike FHA loans or other mortgages, you can’t live in one of the units.
• Some properties are not eligible: DSCR loans generally can’t be used to buy agricultural properties, manufactured homes, multi-family housing with more than four units, and houses with single-room rentals.

When is a DSCR loan a good idea?

Regardless of whether you’re looking to buy your first rental property or your 50th, DSCR loans are a potent choice in many common scenarios. 

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First, DSCR loans can be especially helpful for self-employed borrowers. Many rental real estate investors work for themselves full-time, and that can make qualifying for traditional mortgages challenging. Most conventional mortgage lenders require at least two years’ worth of tax returns showing consistent income over time, and if you don’t have that, you generally won’t qualify for a regular mortgage. However, if you can bring a good deal to your lender’s table, you’d be an ideal candidate for a DSCR loan.

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If you’re an advanced investor with multiple properties, DSCR loans are also worth considering. Many lenders won’t approve loans for investors who already have multiple mortgages, no matter how strong the income-generating power of these investments. Fannie Mae won’t accept more than 10 mortgages per borrower, for example, making it harder for lenders to sell these loans and thus less likely to issue them in the first place. Lenders who offer DSCR loans view multi-property investors as more of an asset than a risk, however, since they’re able to demonstrate a track record of success. 

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Finally, a DSCR loan is a good choice if you’re looking to finance most of the cost of a rental property. Smaller funding methods such as home equity loans or home equity investments can be a good option for debt-averse investors without significant cash reserves. If you’re looking to pay off your rental property sooner rather than later and you already have equity in other properties that you can leverage, you may not even meet the minimum DSCR loan amounts with some lenders. 

Final thoughts

Investing in real estate can be an important tool in unlocking the door to financial freedom. In order to unlock the door to your rental property, however, it’s important to be aware of all of your financing options. For many people, DSCR loans offer the best blend of deal-based underwriting and flexible loan options to continue with their real estate investing journey. Now that you understand the meaning of DSCR loans, you can decide whether this financial product is right for you. If you are looking for other options for paying for an investment property, consider seeing how much you can get with a Home Equity Investment (HEI). 

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