DSCR Loan vs Conventional Loan
If you are a new or seasoned real estate investor, it can be difficult to qualify for traditional forms of financing, such as conventional loans for first-time buyers. Fortunately, investors can use alternative financing options if a potential investment doesn’t qualify for a conventional home loan.
One such option is the debt service coverage ratio (DSCR) loan, which is a type of financing that allows borrowers to qualify based on their DSCR ratio rather than traditional income verification methods. This type of loan is very popular among real estate investors, as it allows them to qualify for financing based on the projected income of a property.
So, when it comes down to it, you may be wondering about the differences between a DSCR loan vs conventional loan. Oftentimes, the better financing option depends on your specific needs. In this article, we compare the strengths and weaknesses of each loan type so that you can decide which is best for you.
- What Is a DSCR Loan?
- What Is a Conventional Loan?
- DSCR vs. Conventional Loan: Which Is Better?
- Find the Right Loan for You
What Is a DSCR Loan?
DSCR loans are a type of financing that offers approvals based on the income from a rental property’s ability to cover the expenses of one or more investment property loans.
DSCR loans, because their approval is based on the property’s operational data, have no income requirements, and often guidance is less restrictive and more flexible than conventional fixed-rate mortgage loans.
What Is a Debt Service Coverage Ratio?
To understand how to use a DSCR loan, it is essential to know what a debt service coverage ratio is. Traditionally, the DSCR offered insight into a company’s financial health, measuring its ability to meet current debt obligations by comparing those debt obligations to current cash flow. When it comes to real estate investing, DSCR can be used to determine how likely a borrower is to pay back their loan by evaluating the amount of debt they have and comparing that to gross rental income.
How to Calculate DSCR
There are two main components used to calculate the DSCR:
- Gross Rental Income
- Total Debt Service or Total Monthly Mortgage Related Expenses
To calculate the debt service coverage ratio, substitute the income and expenses for your particular rental property’s situation. The equation for DSCR is as follows:
DSCR = Gross Rental Income / Total Debt Service
What Is a Good Debt Service Coverage Ratio?
While there are no formalized industry standards, most lending institutions consider a DSCR at or above 1.25 to be strong. In most cases, lenders want to see a DSCR of at least 1 unless there are extenuating and extraordinary circumstances that may offer large compensating factors. A DSCR of 1 means that the income generated by the rental property only covers the costs of maintaining the property. If the DSCR ratio is at least 1.25, the borrower will have more of a financial cushion.
Is a DSCR Loan Conventional?
No, a DSCR loan is a specialty type of mortgage that would not be considered a traditional home loan. Rather, a DSCR loan falls under the umbrella of Non-QM loans, which offer borrowers alternative financing methods. Oftentimes, Non-QM loans such as DSCR loans allow borrowers to secure financing without having to go through typical income verification methods.
DSCR Loan Requirements
The DSCR loan is designed for real estate investors. And while these loans offer an alternative and more flexible path to rental property ownership, there are still some fundamental loan qualifications for these unique loans. The following requirements apply when taking out a DSCR loan at Griffin Funding:
- Minimum credit score of 620.
- Minimum DSCR of .75
- 12 months of cash reserves for DSCR ratios less than 1
Reach out to the team at Griffin Funding for a full list of DSCR loan requirements.
Benefits of a DSCR Loan
DSCR loans are designed for individual real estate investors or investment companies. Using a DSCR loan comes with several benefits, such as:
- No income verification required
- No job history required
- Closing times tend to be quicker than conventional loans
- Access loan amounts up to $5 million
- Unlimited cash out
- Interest-only options available
- DSCR loans can be used for short- and long-term rentals
- Close DSCR loans in the name of your LLC
Borrowers find DSCR loans advantageous as these loans allow them to buy a rental property when they previously could not secure conventional financing. The DSCR loan is also hassle-free and has no income verification requirements, which means no W-2s, pay stubs, or tax returns are required for approval. An added benefit is that DSCR loans have no limit on the number of properties an investor may choose to finance. Essentially, this opens an opportunity for certain investors to expand their portfolios.
Drawbacks of a DSCR Loan
Because the DSCR loan is designed to lend outside traditional lending scenarios, investors will find that the minimum down payment requirements for DSCR loans often exceed the down payment required by conventional mortgages. Additionally, borrowers may find that there tend to be higher interest rates, more fees, and more closing costs associated with DSCR loans vs conventional loans.
What Is a Conventional Loan?
Conventional home loans are what most people refer to when they discuss home loans. The conventional loan is what many individual borrowers use to purchase their home and the loan terms for conventional loans typically range from 10 to 30 years. This type of loan can be configured as a fixed-rate or adjustable mortgage, depending on whether the borrower wants a fixed or fluctuating interest rate.
In order to secure a conventional home loan, a borrower must qualify by meeting the criteria set by the lender. Generally, potential borrowers must prove consistent income by providing relevant tax documents and demonstrate employment by providing job history. It can be difficult to qualify for a conventional loan if you don’t work a traditional job or don’t rely on a conventional income stream.
Benefits of a Conventional Loan
Conventional financing offers some of the lowest interest rates in the mortgage business, but these low rates do require borrowers to meet certain loan standards. Compared to DSCR loans, conventional loans offer lower down payment options and more competitive interest rates.
And, because of the size of the market, there are many lenders and conventional loan types from which to choose, which may not be the case in the smaller DSCR lender niche.
Drawbacks of a Conventional Loan
Conventional loans are highly regulated, which makes qualifying a bit of an arduous task. It can take a long time to qualify for a conventional loan and receive funding. Plus, there are often several restrictions on how the property you’re purchasing can be used. So, if you are a real estate investor who is in a hurry, conventional financing may prove frustrating.
DSCR vs. Conventional Loan: Which Is Better?
It is impossible to say whether a DSCR loan or conventional loan is better, as the right loan will depend on your unique needs and goals. Like most things in life, the loan that will be most suitable will be highly personal and depend on the borrower, their goals, and the property in question.
Model house, paperwork and cash money on a desktop: real estate, home loan and investments concept
In general, conventional loans tend to be best if you’re an individual with a traditional job who is seeking to purchase your own home to live in. On the other hand, DSCR loans can be better suited for real estate investors who want to access a significant loan amount, but don’t have the income to qualify for the loan amount they want through traditional means.
Find the Right Loan for You
A DSCR lender will focus on and analyze the cash flow and property expenses when making an underwriting decision. This process is an ideal option for real estate investors who may have trouble verifying their income. Still not sure whether a commercial loan vs conventional loan is right for you? Reach out to our team online or call us at 855-394-8288 and we can discuss the right financing options for your needs.
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