As the cost of living increases, many people are looking to supplement their income through side hustles or gig work; however, there are only so many hours in a day, and it can be difficult to find the time to add part-time employment to your already hectic schedule. This is why many seek low-effort ways to improve their finances while preparing for their future.
Buying real estate is one of the best investment strategies, as it holds its value well, but many struggle with the complexities of finding a mortgage that is well suited for commercial real estate: conventional home loans are geared toward residential consumers, and their stringent requirements can make it hard for investors to quickly add to their portfolio.
This is why so many investors rely on Debt Service Ratio Income (DSCR) loans, which are specially developed for commercial real estate. Today, we’ll discuss these loans and how to use them for maximum benefit in your real estate endeavors.
How Does a DSCR Loan Work?
A DSCR loan relies on the property’s income-generating potential rather than the financial metrics of the borrower; this means that instead of your own tax returns and pay stubs being scrutinized, lenders will assess how much the property makes and how well it can cover its debt service. Using a DSCR loan calculator, you’ll divide the property’s rental income by the mortgage, insurance, and taxes to create a ratio. Any number above 1 means that you’re generating profit, and most lenders will want to see a ratio of 1.25 or higher to ensure that you can easily cover the mortgage and any other expenses.
What Do You Need to Apply for a DSCR Loan?
Unlike conventional loans, all that the lender will need from you regarding your personal finances is your credit score; you won’t need to provide tax returns, pay stubs, or a list of your other creditors. The primary documentation you must submit is about the property, including its appraisal and a rent schedule proving its previous income. This will be used to calculate the DSCR and approve you for purchase.
However, there is one major similarity between a DSCR loan and a conventional loan: you need to provide a down payment. As commercial real estate loans are riskier for lenders, you typically require a higher down payment, often 20% or more. In addition, you’ll pay closing costs, as you would with any property purchase.
Using DSCR Loans to Their Best Effect
Something unique about DSCR loans is that there is no hard limit to how many properties you can include in a single mortgage, so you will often get the best results if you select numerous properties and calculate their DSCR to ensure that their combined ratio is 1.25 or above. This way, you can expand your portfolio much faster than you would with a conventional home loan, generating more income and preparing yourself for your next purchase.
DSCR loans often have a prepayment penalty: this means that you will have to pay a percentage of the principal as a penalty fee should you make extra payments in the first five years. Typically, this is on a “step down” schedule, meaning that you might pay a 5% fee if you pay ahead on the first year of the mortgage, then the percentage will drop to 4% the next year, and so on. There is usually only a prepayment penalty for the first five years.
Because of this penalty, it is often better to bank extra income during this time; then, should you choose, you can begin paying ahead when your mortgage has seasoned for five years.
Many investors will refinance their loan once their original seasoning period is over, but it’s crucial that you time this correctly to ensure that you will not be paying a higher interest rate than you would have with your original loan. This is especially true because interest rates for commercial real estate loans are typically higher than for residential real estate. Watch market conditions carefully and sign up for notification services that will alert you when rates drop, then start the refinancing process.
Lastly, the crucial element of a DSCR loan is its debt service coverage ratio, and this should be one of your foremost concerns throughout your time as a landlord: understanding and applying DSCR calculation isn’t just helpful when you apply for a loan, but also as you ascertain when you can raise rents. The higher your ratio, the more profit you’ll be able to garner from your real estate, so pay attention to the average rental rate in your area and increase accordingly.
Real estate is one of the best investments you can make, and leveraging specially-made mortgage products for commercial investors will make it exponentially easier to access funding and build your portfolio. Savvy use of DSCR loans can put you ahead of the competition, so make the best use of this unique offering by researching your options and developing a long-term plan.