DSCR Loans (Debt-Service Coverage Ratio Loans)

Getting funding can be an obstacle for real estate investors, both new and experienced. A borrower’s income, credit history, and personal finances are the main factors in traditional mortgage financing, but these elements may not serve investors well, particularly when income isn’t accurately reflected on tax returns.

In this situation, a debt-service coverage ratio (DSCR) loan may be a viable alternative for investors with a portfolio of properties that generate income. By focusing on a property’s capacity to produce income instead of a borrower’s personal finances, DSCR loans provide a unique solution.

This article will explain what DSCR loans are, how they work, and how they can provide a path to financing an investment property without the need to provide traditional income documentation.

What is a DSCR Loan?

A DSCR loan is a type of non-qualified (non-QM) mortgage designed primarily for real estate investors. Instead of evaluating the borrower’s income, lenders use the debt-service coverage ratio to determine loan eligibility. This ratio is a measure of a property’s net operating income (NOI) relative to its debts.

How is DSCR Calculated?

Calculating a debt-service coverage ratio is done to assess whether a property generates an income high enough to cover its debt obligations; namely, loan payments. In other words, it tells lenders whether the investment in question pays for itself.

The formula used to calculate this ratio is as follows:

For instance, if a property’s net operating income is $90,000 and its debt obligations total $72,000, the DSCR would come to 1.25:

DSCR = $90,000 ÷ $72,000 = 1.25

In this example, a DSCR of 1.25 would mean that the property’s NOI is 1.25 times (or 125%) greater than its debt service obligations.

What Does a DSCR Mean?

The answer to the above calculation is important, as it gives investors and lenders an idea of how much of the property’s income covers its debt:

Lenders use a DSCR to:

• Determine loan eligibility: DSCR helps lenders determine if a borrower qualifies for financing and whether they pose a risk for default.
• Set loan terms: DSCR can impact interest rates, loan amounts, and repayment schedules.

DSCR Loan Requirements

Lenders typically look for the following when assessing a DSCR loan application:

Benefits of DSCR Loans

• Ease of qualification: No W-2s, pay stubs, or tax returns required, as loan qualification is based on rental income.
• Streamlined underwriting: Focuses on property performance instead of tax returns for faster underwriting.
• Flexible income sources: Ideal option for borrowers with irregular or seasonal income.
• Personal asset protection: May be closed in an LLC’s name, making it possible to purchase an investment property through a business.

DSCR Loan Drawbacks

• Higher interest rates: Due to the higher risk for the lender, DSCR loans tend to come with higher interest rates compared to traditional mortgages.
• Larger down payments: Lenders typically require a higher down payment — from 20% to 30% or more — on a DSCR loan compared to a conventional mortgage to mitigate risk.
• Not for primary residences: DSCR loans are meant for investment properties that generate a positive cash flow and are not designed for financing primary residences.

DSCR Loans vs. Second Home Mortgages

When it comes to investing in real estate, the line between an investment property and a second home can blur, despite the common goal of generating an income from the property. However, your intentions matter when it comes to financing, and understanding the difference between DSCR loans and mortgages used to buy a second home is essential.

Investing in a property solely for income is typically driven by cash flow and long-term returns, with tenants living there full-time. On the other hand, a second home is used partially by the owner, then rented out to others when unused by the owner to offset costs. While both paths can build wealth, they each cater to different goals, and require different forms of financing.

How to Improve Your DSCR

As noted, your DSCR plays a key role in your ability to secure a DSCR loan to finance an investment property. If your calculated DSCR is too low (under 1.0 to 1.25), consider taking time to give it a boost using any of the following strategies:

• Increase rental income: If the local market permits, consider raising rents or add amenities to justify higher rent prices. Just be sure to comply with local regulations surrounding rent increases. In Washington State, no rent increases are allowed in the first 12 months of a lease. Then, rent increases cannot exceed the lesser of 7% plus the CPI or 10% in any 12-month period.
• Reduce operating expenses: Cut unnecessary costs to minimize operating expenses to increase your DSCR. Areas you may consider slashing costs include excessive maintenance or management fees.
• Refinance existing debt: If you already have financing in place, consider whether refinancing is a viable option to lower your interest rate or extend the loan term to reduce monthly payments.
• Make a larger down payment: A bigger upfront payment reduces the loan amount and, therefore, the debt service ratio.

FAQs

• Can DSCR loans be used to finance a primary residence?

No, DSCR loans are designed for investment properties that generate cash flow, and are not used to finance a primary residence.

• What is a good DSCR for loan approval?

Most lenders look for a DSCR of at least 1.0 to 1.25.

• Who is a DSCR loan most suitable for?

DSCR loans are suitable for real estate investors, self-employed borrowers, and those with non-traditional sources of income.

• Does my personal income need to be verified?

Generally, no. Traditional documents needed for standard mortgages — like tax returns, pay stubs, or W-2s — are usually not required. Instead, lenders focus on the property’s cash flow.

• What types of properties are eligible?

Eligible properties include single-family rentals, multifamily unit properties, and some commercial buildings, as long as they generate sufficient rental income.

• Are DSCR loans more expensive than traditional mortgages?

Yes, DSCR loans often come with slightly higher interest rates compared to traditional mortgages as a result of the alternative underwriting approach.

• Where can I apply for a DSCR loan?

Look for a mortgage lender, like Sammamish Mortgage, with experience underwriting these unique loan types.

Final Thoughts

DSCR loans provide a flexible and powerful financing option for investors looking to purchase cash-flowing properties. By using the investment potential of a property instead of your personal finances, DSCR loans make the path to investing in real estate more accessible. Be sure to work with an experienced mortgage company, like Sammamish Mortgage, to help you navigate the process and choose the loan structure that’s most suitable for you.

Need Financing?

If you’re looking to purchase an investment property in the Pacific Northwest region and prefer to use the property’s potential income in place of traditional income documentation to qualify, we can help. At Sammamish Mortgage, we offer various self-employed mortgage home loan programs for those without traditional employment documentation in WA, OR, ID, CO, and CA. Visit our website to get an instant rate quote, or get in touch with us today to have your mortgage questions answered!