For those seeking to become a real estate investor but whose credit score is less than perfect, it may seem impossible to get qualified for that all-essential home loan that will pave the way to financial freedom. However, it doesn’t have to be so: a conventional mortgage is only one of numerous different products that can help you purchase your first property.
Rather than heading over to a bank or credit union to get your home loan, you can instead work with a private mortgage lender, most of whom offer Debt Service Cover Ratio (DSCR) loans. These loans are special products made for investment properties, which rely upon the house or building’s revenue-generating possibilities rather than the borrower’s own credit score.
To set up a DSCR loan, the lender will assess the property’s income potential during a given timeframe – generally shorter than a conventional mortgage – in comparison to how much it costs upfront. DSCR loans are an excellent option for those who will be relying on the property itself to pay back the loan rather than any outside income, or who cannot qualify for a conventional mortgage due to their financial circumstances.
How do you determine if this product is right for you based on the particular property you’d like to purchase? Let’s take a look at what you should factor in when deciding to apply for a DSCR loan.
You can use the same calculations that the lender will in order to decide whether you can afford the investment
As you might expect from the name, the DSCR is the ratio of asset to liability: it compares how much you will make from the property versus how much you have to pay on the loan. You divide the net operating income (NOI) of the property by the annual debt service to get a ratio, similar to the debt-to-income ratio that’s used to access a residential mortgage.
In order to get these numbers, you need to perform some research on average rental prices in the area; if you have a property in mind already and it has a rental history, you should ask the seller for this information so that you can calculate your DSCR.
Let’s take a look at a very optimistic – and very simplified – example to get a better idea of how this works. Assume that the current rent on a one-unit property is $1,500 per month, which comes out to $18,000 per year. You have taken out a 30-year DSCR loan with an APR of 7.5% on a $150,000 mortgage; this brings your annual mortgage costs to $13,200. In this scenario, your DSCR would be about 1.36.
Lenders want to see a ratio of 1.2 or higher, meaning that your property makes 1.2 times the annual cost of the loan. If you had a profile similar to that above, you would easily qualify and have no trouble paying back your DSCR loan, because the return on investment is much higher than the actual costs involved.
Of course, it is generally more complicated than the above example, but this simplified ratio can give you a quick estimation of whether you will qualify for a loan and how tight your margins will be so that you can plan ahead. It can also help you determine whether a property is worth the price based on expected rents, though you might need to factor in other elements, such as repairs, when calculating your ratio.
A good private lender will help you develop a loan structure and repayment plan that works for you
Because private lenders are not beholden to the same regulations as banks and credit unions, they have more flexibility when it comes to their loan products, meaning that you can work with them to access a DSCR loan with stipulations that you can afford. This may include the loan length and amount, interest rates, prepayment penalties, amortization schedule, and closing costs.
Though you have more bargaining power here, there are also fewer safeguards in place to protect you, so you should go into this with a clear understanding of the risks; a great private lender will also be transparent about the downsides of their products, and they will not pressure you into taking out more than you can afford.
You may find it helpful to work with a real estate lawyer or accountant as you decide whether this property and loan is a good investment for you, as they will have experience in negotiating these kinds of deals and looking closely at the fine print. Regardless of what you choose, being more aware of the mortgage products available to you will allow you to make a more informed decision when you’re ready to jump into the fascinating and fast-paced world of real estate investing.
