It’s been nearly a decade since the Qualified Mortgage rule went into effect.
As a quick refresher, loans that feature risky terms, such as interest-only, negative amortization, or balloon payments aren’t permitted under the QM rule.
The same goes for mortgages with loan terms beyond 30 years, such as 40-year mortgages.
On top of that, all residential home loans have to abide by the ability-to-repay (ATR) rule, which requires lenders to determine if a borrower can be reasonably expected to repay the loan.
However, one type of loan can be exempt from the QM rule and ATR rule, the business purpose loan.
DSCR Loans Live Outside the Strict Mortgage Rules
One of the most popular loans to come out of the non-QM space has been the DSCR loan, which stands for debt service coverage ratio.
Because it’s a business loan, it is exempt from the ATR/QM rules.
This means the borrower doesn’t need to document income or employment, and a DTI ratio isn’t generated.
Instead, the property’s cash flow is considered to determine if the loan can be paid back.
There are also prepayment penalties on these loans in most cases.
Some critics have argued that these types of loans are a new version of stated income, known in the past as liar’s loans.
Others say it’s a new version of subprime lending because the borrower doesn’t need to fork over their tax returns or perhaps even say what they do for a living.
Instead, they simply need to provide a lease and use that rent to offset the housing payment.
Seems too simple, right? Well, remember that these loans are geared toward real estate investors who own rental properties.
So what they do for a living, assuming it’s not owning rental properties, may be of little consequence.
Instead, lenders that originate DSCR loans are interested in the ability of the property to generate income.
This allows these types of loans to live outside the stricter rules that apply to most other residential home loans.
Remember the Stated Income Loan?
The stated income loan, which is often referred to as a “liar’s loan,” was extremely popular in the early 2000s.
It met its demise when the housing market crashed, setting off the Global Financial Crisis (GFC).
In short, a borrower who submitted a stated income loan only had to state their monthly gross income on the application, as opposed to providing pay stubs.
While they did have to verify their employment and credit history, there was quite a bit of wiggle room with regard to income.
Nobody verified it other than determining if it “made sense” based on the job description.
And to make matters worse, not much in the way of assets were necessary to get approved.
The loan-to-value (LTV) ratio or combined LTV (CLTV) could go up to 100%.
But wait, there’s more. The underlying loan could also feature all types of exotic features, such as negative amortization, or be a volatile short-term adjustable-rate mortgage such as the 6-month ARM.
If that wasn’t risky enough for you, there was also no doc option, which didn’t require the documentation of income or assets, or employment. Like stated income loans, 100% LTV/CLTV was often A-OK.
DSCR Loans Don’t Require Much Documentation But There Is One Key Difference
So what about DSCR loans. They don’t even require income from the borrower because the operating income from the subject property is used instead.
No debt-to-income (DTI) calculation is made since the loans typically aren’t subject to the QM/ATR rule.
And they offer all types of traditionally exotic options, whether it’s an interest-only period, a 40-year loan term, prepayment penalty, and so on.
Does this mean the borrower isn’t qualified for the loan? Not necessarily.
One huge compensating factor for these loans is the LTV is often capped at 80% or less.
This means the homeowner (or real estate investor as most are) must have a solid amount of equity or down payment.
The borrower also needs to document an ample amount of asset reserves.
And if there are additional risk factors on the loan, the LTV drops even lower.
In the past, more layered risk may have just resulted in an even higher mortgage rate.
This doesn’t mean default can’t and won’t happen on these loans, but there’s a much bigger guardrail if something goes wrong.
Meanwhile, those mortgages from 2006 fell into negative equity positions almost immediately when home prices took a turn for the worse.
(photo: Marcin Wichary)