When mortgage lenders evaluate a borrower’s loan application, many factors are considered to determine creditworthiness. Among these are credit scores, employment history, downpayment size, debt-to-income ratio and the submission of all required documentation.
Not all borrowers, however, are able to provide the documentation that is required to qualify for a conventional loan. This is especially true of self-employed individuals who lack a W-2 income. In these cases, a borrower who wishes to purchase a home seeks out a nonqualified mortgage (non-QM) lender that has more flexible underwriting guidelines and specializes in working with self-employed borrowers. Non-QM loans are those that cannot be sold to the federal government or the government-sponsored enterprises.
One particular subset of self-employed individuals who frequently work with non-QM lenders are real estate investors. Because many investors take deductions and write off business expenses on their properties, they do not qualify for conventional loans. Instead, they work with non-QM lenders that offer mortgages based on the potential income that an investment property can generate, rather than the income of the investor.
One primary calculation that lenders use when evaluating an investment property is to determine its debt-service-coverage ratio (DSCR). This ratio helps the lender to ascertain whether the property is generating sufficient income to service the loan debt. Mortgage originators can help clients who want to invest in real estate by understanding these types of products, which are referred to as DSCR loans.
Calculating income
To assess the real estate investor’s ability to repay, the lender calculates the debt-service-coverage ratio. This ratio compares the annual gross rental income with the anticipated mortgage expenses, such as principal, interest, taxes, insurance and homeowners association fees — omitting only utility fees.
By doing so, the lender makes sure that the borrower has enough coverage within their revenue streams to cover potential debt liabilities over time. To calculate the DSCR, an investment property’s gross rental income is established.
Generally, this figure is based on a lease agreement and/or an appraiser’s comparable rent schedule. The lesser of the two figures is typically used to calculate the ratio. Next, it is necessary to determine a property’s annual debt. For loan qualification purposes, the annual debt includes the total principal, interest, taxes and insurance. Finally, the annual gross rental income is divided by the annual debt and that calculation yields the DSCR.
For example, an investor may be looking to buy a home that has a monthly rental income of $2,500 and debt payments of $2,000. When you divide the rental income by the debt payments, you get a DSCR of 1.25. This means that the property generates 25% more income than it costs to own.
Lenders formulate a borrower’s DSCR to ensure that an investment property has sufficient income to service its debt. It is also a way for lenders to evaluate the merits of a prospective loan and a means to mitigate its risks.
Assessing risk
Typically, lenders want to ensure that borrowers can cover current debt obligations without taking out additional loans, which is reflected in a debt-service-coverage ratio of 1.0 or higher. Anything less than this could signal that the borrower has insufficient funds flowing through and may need external resources for repayment.
Even if the DSCR is close to 1.0 — say 1.1 — some lenders might consider the property to be financially vulnerable, since a minor decline in cash flow could render it unable to service its debt. Consequently, some lenders may require borrowers to maintain a minimum DSCR throughout the life of a loan. Other lenders may deem a loan to be in default if it falls below an agreed-upon minimum ratio.
Although there is some variation among lenders, most are willing to make DSCR-based loans with a ratio of 1.0 or higher, while some lenders are even willing to make loans with a ratio below 1.0. Even if they generally frown on negative cash flow situations, some lenders are willing to consider them, depending on a property’s particular circumstances.
For example, loans with ratios below 1.0 are usually purchase loans that involve home improvements or major remodels that will be made to increase the property’s monthly rent. In addition, a DSCR loan with a low ratio might be granted on a property with substantial equity or the potential for higher rents in the future.
It should be noted that interest rates on loans with ratios of 1.0 or higher are generally more favorable, while a DSCR ratio of less than 1.0 generally requires 12 months of reserves. Non-QM lenders that offer DSCR loans are experienced in working with real estate investors and can develop pragmatic solutions to the benefit of both lender and investor alike.
Benefiting borrowers
DSCR loans are good for both new and experienced real estate investors. If they’re new, this loan can help them get started. If they’re experienced, the proceeds can give them the money they need to grow their wealth.
So, whether they’re just starting out or they’re seasoned pros, a DSCR loan is a good way to finance real estate investments. There are many other benefits for investors who utilize DSCR loans to fund the purchase of investment properties:
- Personal income. DSCR lenders do not look at a borrower’s personal income during the application process, making it easier to qualify with lower levels of income.
- Time to close. With a DSCR loan application, a borrower’s financial information is not required and employment gaps needn’t be explained — resulting in a smooth, swift process from application to closing.
- Multiple properties. DSCR loans allow clients to borrow money for multiple properties at the same time. This is different from other types of mortgages, which require borrowers to pay off any existing loans.
- Unlimited cash out. With the DSCR loan, your borrower can have peace of mind knowing they are able to access as much cash flow as needed for any unforeseen circumstances. This unlimited cash-out option offers a smart alternative when looking into convenient and reliable loan options.
- Foreign nationals. Non-U.S. residents are eligible for DSCR loans. Typically, the maximum loan-to-value ratio is 80%, so foreign nationals need to put down at least 20% of the property’s purchase price to be financed with a DSCR loan. These loans may include higher interest rates and fees, and the applicant will need to provide proof of income from the rental property.
An impressive debt-service-coverage ratio is the key to proving there is enough cash flow on hand to cover the loan payments. A higher ratio means better financial security, so if you want the comfort of knowing your borrower’s debt can be serviced without difficulty, aim for the highest ratio possible.
DSCR calculates whether an investment property is making enough money to cover the mortgage or not. It is an effective gauge for non-QM lenders to determine the maximum loan amount on an investment property. ●
