The Pros and Cons of Using a DSCR Loan to Buy an Investment Property (2024)

Debt service coverage ratio loans have become an increasingly popular option among investors in our community. But what are they? And why are investors choosing these loans over more traditional options? In this article we cover the pros/cons of these types of loans, and how to avoid some of the traps these loans might pose for inexperienced investors.

If you’re a real estate investor, you’re probably familiar with using traditional residential loans to buy single family homes and 2-4 unit multifamily properties (collectively known as 1-4 unit properties).

These loans are often referred to as Qualified Mortgages or QM for short. These are your loans backed by Fannie Mae and Freddie Mac and because of that, follow strict underwriting guidelines..

There is another category of loan called non-Qualified Mortgages or non-QM. These don’t follow the traditional underwriting guidelines, so lenders can design their own loan guidelines.

One of these non-QM loans is a Debt Service Coverage Ratio loan, which has emerged as an increasingly popular option for investors buying 1-4 unit properties.

In this article, we’ll describe what it is, how to qualify for a DSCR loan, some of the pros/cons, and the pitfalls you can fall into when using one of these loans for an investment property.

What is a DSCR loan?

A debt service coverage loan is a loan that can be used to acquire income-producing properties, but unlike traditional loans, qualifying for these loans isn’t based on your income or tax returns, it’s based on the income that a property generates.

The idea is that the income from the property should cover the loan payments, either in whole with some left over for other expenses or in some cases, just a portion of the loan. More on this below.

Therefore, these loans can be used to acquire any income-producing property such as long-term rentals, mid-term rentals, and short-term rentals.

Note: these loans can also be used to buy other types of income-producing properties but for the purposes of this article, we’ll be focused on investors who are using this type of loan for 1-4 unit residential rental properties.

How do you calculate DSCR?

The typical calculation of DSCR is net operating income (numerator) divided by the debt service (denominator).

Net operating income is the difference between rental revenue and all operating expenses, which include things like property management, property taxes, insurance and utilities.

Debt service is the principal and interest payment.

DSCR for the purposes of a DSCR loan for 1-4 unit properties is calculated differently.

Instead of net operating income, the numerator is total rental income or gross revenue.

Debt service is also calculated differently. Instead of just principal and interest, you also include property taxes and insurance. This is known as PITI (Principal, Interest, Taxes, Insurance).

What DSCR do you need to qualify for a loan?

The usual cut-off is 1.25.

This means that gross revenue has to be 25% more than the PITI. For example, a gross revenue of $1,250 per month and PITI of $1,000 per month would have a DSCR of 1.25.

However, it is possible to get a DSCR loan for as low as 0.75. But in order to qualify, you need to set aside reserves, which is money to cover up to 12 months of PITI. In addition, you can expect the interest rate to be higher.

What are the pros of a DSCR loan?

There are a number of pros that investors should be aware of.

The first is, it’s an option for those who are having trouble getting loans because of the number of investment properties they already own.

Sometimes lenders, especially if you are working with a lender that doesn’t have a lot of experience with lending for investment properties, don’t know how to account for things like depreciation. Many of our investors use depreciation to create paper losses on their tax returns and in turn, use these losses to shelter W2 or 1099 income (using real estate professional status or the short-term rental tax loophole). Lenders look at this and think you’re losing money on your properties, when in fact you are cashflowing.

Another instance where a DSCR loan is particularly helpful is for those who don’t have W2 income but instead have 1099 income. Without W2 income, it’s harder to qualify for a QM loan.

One other pro for investors is the ability to buy a property in an LLC. Since many of our community are doctors and high-income professionals, they are hyper-focused on asset protection (as they should be). Buying a property in an LLC directly gives you additional anonymity protection.

What are the cons of a DSCR loan?

One of the biggest cons of a DSCR loan is the higher mortgage rates and fees.

If you have been following us, you know that we encourage you to learn how to analyze deals and only buy properties that cashflow well.

A higher mortgage rate and fees means lower cashflow.

What are the cons of a DSCR loan that nobody is talking about?

Probably one of the biggest cons that nobody is talking about is that it can encourage a new breed of investors to get in over their head.

How does this happen?

This can happen when they buy properties that don’t produce enough income or cashflow.

Part of this is that they don’t know what they’re doing. As a result, they don’t buy the property at a discount (immediate appreciation). They don’t know how to predict a property’s performance with enough accuracy using a deal analyzer. They don’t force appreciation, which is one of the best ways to de-leverage.

As a result, these investors get over-leveraged on properties that don’t produce income.

What happens next?

The income from the property doesn’t cover the expenses and they go into foreclosure.

Is this the new NINJA loan?

Leading up to The Great Recession, there was a type of loan called NINJA loans. These loans did not require income verification, no job. Similarly, DSCR loans don’t require income verification or a job.

So naturally you might wonder, is this just a NINJA loan in sheep’s clothing?

Maybe there are elements of the NINJA loan, but it does seem like the qualifications for these loans are more strict.

One difference is that leading up to the 2008 recession, you could go out and buy a non-income producing property using a NINJA loan. In contrast, the DSCR loan requires that the property produces income.

So the DSCR loan can’t be used to buy something like land, which doesn’t generate any income. Land investing is a more speculative type of investing, akin to gambling.

Should you use a DSCR loan to buy your next investment property?

Despite the risks of a DSCR loan for inexperienced investors, there’s nothing inherently wrong with a DSCR loan.

Think of it as a tool in your toolkit.

It’s an option that you have when it makes sense.

However, if you’re using these loans and you don’t know what you’re doing, or you’re using it without looking at the potential pitfalls, then it’s not a great option.

No matter what you do, you should work with a reputable and trusted lender.

You want someone who can help you think through whether it is a good option for you. Not just someone who is trying to sell you a loan.

We have been working with our trusted lender for nearly a decade. We have personally purchased numerous properties with them. Thousands of our students have worked with them over the last several years.

If you want to work with them too, CLICK HERE for an introduction.

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