One of the most popular types of non-QM loans is the “DSCR loan,” which stands for debt-service coverage ratio.
It is a loan geared toward real estate investors who may be asset rich but cash poor. Or those who simply have complicated finances.
In a nutshell, borrowers are qualified based on the cash flow of the property instead of their own personal income.
This differs from traditional mortgages where the borrower’s own job, income, and assets are qualifying factors.
How Does a DSCR Loan Work?
As noted, the DSCR loan considers the property’s operating income as opposed to the borrower’s own personal income.
They are reserved for non-owner occupied properties that are rented out by the homeowner, including short-term rentals (STRs).
This means the borrower’s income isn’t disclosed, nor is a debt-to-income (DTI) ratio generated.
Instead, the lender calculates a debt service coverage ratio (DSCR) to determine eligibility and loan pricing.
Simply put, the loan underwriter must ensure the property generates sufficient income to offset most or all of the associated debt.
This key figure will determine the maximum loan amount, minimum down payment, and required credit score to qualify.
It’s the focal point for the underwriter as the property itself carries all the weight, not the borrower.
This counters a traditional mortgage loan, where collateral is but one of the many qualifying criteria.
How to Calculate the Debt Service Coverage Ratio
Different lenders have different approaches when it comes to calculating the debt service coverage ratio.
But a common way is to divide the property rent by the principal, interest, taxes, and insurance (PITI).
This includes the mortgage payment itself, property taxes, and homeowners insurance. And any association dues if applicable such as those from a homeowners association.
In terms of the rent used, it may be the higher of market rent or the actual rent (assuming there is a lease in place), at the underwriter’s discretion.
But it is possible that a lower rent will be used if the rent seems excessive for the area and/or property.
For example, let’s say a property rents for $3,500 per month and the PITI is $2,500. There is also a monthly HOA due of $150.
In total, the PITIA payment would be $2,650 versus a monthly rent of $3,500.
To determine the ratio, you divide the rent ($3,500) by the PITIA ($2,650) to come up with 1.32.
Generally a ratio above 1.00 is sufficient to get approved for a DSCR loan.
But let’s suppose the PITIA is $3,200 and the rent only $2,500. Then you’ve got a ratio of 0.78. Some lenders may not approve the loan.
Note that DSCR lenders will have a “minimum DSCR,” in place, likely at .80 or higher. Others may require a DSCR of at least 1.00.
So if your ratio is too low, that could be grounds for denial, regardless of other loan attributes.
Other lenders may only consider the principal and interest for the mortgage, but use net rental income that factors in expenses.
For example, you might only get to use 75% of the rent against the P&I payment.
In short, the higher the ratio the better. And there may even be pricing improvements for those with ratios above a certain level.
What is a Good DSCR Ratio?
The simplest answer is the higher the DSCR ratio, the better.
Most lenders want the DSCR to be above 1.00 in order to approve the loan.
A ratio above 1.00 means the subject property generates positive cash flow.
For example, $2,500 in monthly rent vs. a $2,000 housing payment will result in a DSCR ratio of 1.25.
Conversely, $2,000 in rent vs. a $2,500 housing payment will result in a ratio of 0.80.
As noted, some DSCR lenders may allow a ratio as low as 0.80, but others may not.
Assuming they allow it, you may be limited to certain property types or LTVs if the ratio is below a certain threshold.
Additionally, the pricing could be worse and/or you may need more cash reserves to qualify.
What Down Payment Is Required for a DSCR Loan?
While it might be possible to get a mortgage with no money down via the USDA or VA, or just 3% in the case of Fannie Mae and Freddie Mac, DSCR loans typically require at least 20% down payment.
Because the borrower is qualified via the property rents, as opposed to a full underwrite that considers income, assets, and employment, there is inherently more risk.
Like a traditional mortgage, when there is more risk, down payment requirements are higher.
As such, you likely find that the maximum loan-to-value ratio for a DSCR loan is 80%.
This maximum LTV will also fall as your FICO score goes down. So if you have a sub-620 FICO, the max LTV might be capped at say 65%. Or you won’t be eligible at all.
The same is true for property characteristics, such as number of units and/or property value.
A 2-4 unit property may be capped at a lower max LTV. The same could be true for a large loan amount.
And a cash out refinance will have a lower maximum LTV than a home purchase or rate and term refinance.
What Credit Score Is Required for a DSCR Loan?
Speaking of credit scores, it’s possible to get a DSCR loan with a relatively low FICO, potentially even below 600.
You certainly don’t need good credit for a DSCR loan, but the higher your score, the lower the rate and the more options you’ll have.
It will depend on the lender in question, as requirements and risk appetite will always vary based on the company involved.
However, it’s not uncommon to see minimum scores below 600, as long as the down payment or LTV is fairly low.
Other lenders may require a minimum FICO score of 620, which is the traditional subprime mortgage cutoff.
Or you may need an exception to get approved at a certain lower score.
Credit scores aside, you may qualify for a DSCR loan even if you’ve had negative credit events in the recent past, including late mortgage payments, short sale, or bankruptcy.
But because interest rates are quite high, you’ll want to strive for a high credit score to obtain the lowest rate possible.
What Is the Maximum Loan Amount for a DSCR Loan?
One nice thing about DSCR loans, other than the relatively flexible underwriting guidelines, is the high maximum loan amounts.
Many lenders will allow loan amounts over $1 million, up to $5 million, $10 million, and some will go as high as $20 million.
And even if they have lower max loan amounts, it may be possible to get approved for a larger loan amount on a case-by-case basis.
Just note that once your loan amount exceeds a certain threshold, say $1.5 million, you may be on the hook for two appraisals to determine the valuation.
This will be an added cost, but is necessary given the high-dollar amount being lent out.
What Types of DSCR Loans Are Available?
DSCR loans come in many varieties, including both fixed-rate and adjustable-rate options.
This means you can get a 30-year fixed, a 5/6 or 7/6 ARM, and even an interest-only loan.
Speaking of interest-only, it is typically offered for the first five or 10 years depending on the loan term.
And some lenders will allow for 40-year loan terms with a 10-year interest-only period.
This means the qualifying payment can be a lot lower when factoring in the longer amortization and lack of principal repayment.
What Is the Average Rate for a DSCR Loan?
While there’s no average rate for a DSCR loan as there is for conventional loans, the main takeaway is that they’re higher than rates on traditional mortgages.
This all has to do with risk, as investment property loans carry for more risk than owner-occupied properties.
Additionally, because this type of loan isn’t widely available at retail banks and online lenders, pricing will generally be higher.
See our article on non-QM mortgage rates for more on this.
How much higher depends on a number of factors, including the lender’s risk appetite and your particular loan scenario.
Like all home loans, DSCR loans have pricing adjustments for things like credit score, LTV/down payment, loan amount, property type.
The more layered risk you present to the lender, the higher the mortgage rate.
For example, a DSCR loan with a 620 FICO score and 75% LTV will be significantly more expensive than one with a 740 FICO score at 60% LTV.
We could be talking the difference of two percentage points in such a scenario.
Depending on market conditions, this might mean a rate of 8% versus a rate of 10%.
And note that we’re talking about adjustable-rate mortgages, not a 30-year fixed, which will be priced even higher.
Of course, these loans are typically expected to be short-term solutions that are only held for a few years.
Take special care to shop your DSCR loan with multiple banks and/or mortgage brokers since mortgage rates and pricing can vary considerably.
Are There Closing Costs on a DSCR Loan?
Yes, like all other mortgage loans, there are closing costs on a DSCR loan.
This may include an underwriting and processing fee charged by the lender, along with commission to the loan officer, mortgage broker, and account executive if applicable.
Additionally, there will likely be an appraisal fee (sometimes two fees), an entity/LLC fee, credit report fee, flood cert, and so on.
Some of these fees may be baked into the interest rate, while others may need to be paid directly out-of-pocket.
Certain lenders may allow you to use a lender credit to offset some or all of these fees.
And borrowers may have the option to buy down their rate via discount points if they wish.
Where Can I Get a DSCR Loan?
If you need a DSCR loan, you’ll need to contact a lender that offers non-QM loans. Many of these lenders operate via the wholesale channel.
This means you’ll need to get in touch with a mortgage broker first who is approved to work with a lender that offers DSCR loans.
From there, they’ll be able to shop your loan with all their lender partners that offer such loans to find the best combination of pricing, service, and availability.
As noted, rates and pricing can vary tremendously, so take the time to shop around with multiple brokers/banks.
Pros and Cons of DSCR Loans
- Flexible underwriting guidelines
- Borrower’s income not considered for loan approval
- Low minimum FICO scores
- Lots of loan types including ARMs, interest-only, 40-year terms
- Lots of property types accepted including non-warrantable condos and condotels
- Short-term rental (STR) income can be considered
- Cash out permitted
- No maximum number of properties owned
- Foreign nationals, ITIN, and non-permanent resident aliens accepted
- High interest rates
- Prepayment penalties
- High down payments/ low max LTVs
- Impounds typically required