New and experienced investors are finding the residential housing market increasingly attractive especially with the proliferation of online options for putting properties up for rent. Many potential buyers are unaware of the full range of lending options available in this arena, which go well beyond traditional loan products. For investors seeking to purchase or refinance a residential property that won’t be either a primary or secondary residence, one mortgage product might be just what they need. Mortgage originators should be familiar with this type of loan — debt-service coverage ratio (DSCR) mortgages — and how it can benefit their clients.
The debt-service coverage ratio is just a way to measure whether the amount the property can earn in income can pay for the debt on the property. For example, if a property has a monthly debt payment (mortgage plus property taxes plus insurance) of $1,000, and it can rent monthly for $1,000 (cash flow), the ratio is 1. Basically, the higher the ratio, the greater the profits for the investor (and the less risk for any potential lenders).
So, what is a DSCR loan? It is a non-qualified (non-QM) mortgage product for investment properties that looks primarily at the property’s ability to cover the mortgage payment, rather than the borrower’s ability to repay it. Non-QM loans are unable to be sold to the federal government or government-sponsored enterprises but still need to meet the ability to repay standards.
Instead of extensive documentation of the borrower’s income (W-2s, tax returns, etc.), the lender will look at the appraisal and estimation of the property’s monthly cash flow to determine the viability of a mortgage. The higher the ratio, the greater the likelihood of not only obtaining the mortgage, but also to have more favorable terms, as the borrower will have a larger profit margin to cover unexpected expenses (such as maintenance or rising property taxes).
Differing requirements
A debt-service coverage ratio loan may be the right financial vehicle for many looking to capitalize on the current market — from first-time investors to investors who already own several properties. But the most important thing to remember with these loans is that they cannot be used for primary or secondary residences.
They are for rental properties only; and although the IRS allows for stays of up to 14 days a year in investment properties, many lenders will not allow for any owner occupancy at all. Brokers should check lenders’ specific occupancy guidelines thoroughly to make sure they match their borrowers’ expectations.
Otherwise, the requirements for these loans in general will vary from lender to lender. Many lenders will want a somewhat significant downpayment for a DSCR purchase loan to keep the loan-to-value (LTV) ratio and monthly payments lower. For example, some lenders will only go as high as 85% LTV on a purchase of under $1 million, or only as high as 65% LTV on a purchase of more than $1 million.
While many lenders will be looking for a ratio of 1.25 or higher, there are some lenders that will go lower (and even do no-ratio loans in select circumstances). In addition, some lenders will only work with experienced investors, while others will also work with first-time investors.
DSCR loans can be used for purchases or refinances — including cash-out refinances — depending on the lender. The refinance option may be particularly useful for borrowers who already have investment properties, as they can use the cash-out refinance option on one successful property to create a downpayment for a new purchase, or to pay for needed renovations or upgrades.
Some lenders will even allow for cash-out refinances to be used toward reserves with a sufficient credit score. As with purchase loans, lenders will be looking to keep the LTV low on refinances as well; and many lenders won’t go higher than 75% LTV on a cash-out refinance.
Although these loans look at the property’s cash flow and ability to cover debt, the borrower’s credit does play a role in the financing. A higher credit score will likely result in more favorable terms, particularly interest rates. Unlike traditional mortgages, where many specialized mortgage companies will lend to borrowers with lower credit scores to reach an underserved market, in this arena the credit score cut-off tends to be a bit higher, so check lenders’ guidelines to make sure borrowers’ scores fall within the parameters.
Untapped market
There are many benefits to a DSCR loan for mortgage originators and borrowers alike. Mortgage brokers and originators should educate themselves on these loans and the lenders who provide them, as this is a somewhat untapped market. Many first-time investors — and some seasoned ones, as well — are unaware of this loan product and how it can help them acquire new properties or upgrade their current ones.
“Brokers should seek out lenders with flexibility and experience with financing these types of loans as well as investigate the types of borrowers and loans the lender works with.”
As the DSCR loan centers around the investment property in question, this is a relatively low-documentation loan. The property appraisal and any rental agreements (to reflect income potential) are the main requirements, as well as a current credit report for the borrower. And because these loans are considered “business purpose,” there is no waiting period for federal disclosure laws. Because of these points, DSCR loans offer quick turnarounds with a short closing time.
One additional benefit is these are business-purpose loans so a loan officer can originate these loans for one to four family residential units in certain states without being licensed in that state. This varies from state to state, and by wholesale lenders, so be sure to double-check with your lender.
These loans are highly individualized by lenders, which can be both a benefit and a drawback. Each lender will have its own requirements, LTV and credit score, but because this is already a non-QM loan, some lenders will be able and willing to make exceptions to their guidelines.
For example, many lenders won’t fund a DSCR loan for a borrower who doesn’t already own a primary residence, as it makes the risk of owner- occupancy too high. For a borrower who lives in an area like New York City, the lender will likely make the exception, as it’s not uncommon to rent in the city and own an investment property outside of the metro area.
Another benefit to the DSCR loan is its flexibility per property. Although some lenders will only lend on positive DSCRs, some will go as low as 0.75, or even offer no-ratio loans. These offerings will be particularly useful for borrowers who are looking to create short-term rentals that often rent by the day or week and thus may not appraise for the monthly income required for a positive ratio. These short-term rentals are popular with consumers for their ease of online booking and amenities that a hotel can’t offer; but without regular rental agreements, it makes it more difficult to show they have a positive cashflow.
A final advantage of these loans for investors is the ability to close in an entity name, like a limited liability corporation. Neither Fannie Mae nor Freddie Mac allows that although that is how many investors hold their properties.
In terms of drawbacks for these loans, like with any non-agency, non-QM loan, these loans do tend to have slightly higher rates. Some of these loans may also have a prepayment penalty, depending on the state of origination, so be sure to check with the lender.
New niche
As with any loan product, lenders offering DSCR loans will have a host of wide-ranging restrictions and requirements, some of which may limit a borrower’s options. Brokers should seek out lenders with flexibility and experience with financing these types of loans, as well as investigate the types of borrowers and loans the lender works with.
Some lenders will only lend to seasoned investors (and will require proof of recent activity), while others loan to first-time investors, too. The same applies to owning a primary residence, as well. For some lenders, it’s a requirement; for some it’s an exception; and for others, it is unnecessary.
Other lenders will also work with individual tax identification number (ITIN) borrowers, who do not have a Social Security number, but who live and work in the United States and pay taxes. Learning more about this unique lending product will help mortgage brokers and originators to develop a new niche and meet the needs of more borrowers.
