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The Difference Between DSCR Rental Loans and Conventional Loans

What is a DSCR loan?

Historically these loans only applied to commercial properties but recently asset-based lenders have started using DSCR loans as a way to underwrite and approve loans for 1 to 4 unit residential investment properties. So what is a DSCR loan? DSCR stands for Debt-Service Coverage Ratio which is a formula used to determine if there is enough cash flow from rental income received on the property to “cover” or “service” the outstanding monthly debt on the property.

While it varies between lenders, typically anything between a 1.1 and 1.2 DSCR calculation is considered a sufficient cash flow to cover the outstanding monthly debt (meaning the rent is 100 to 120% of the monthly expenses). Monthly expenses are typically principal, interest, taxes, insurance and any dues if part of a condo association. 

The main benefit of these loans is lenders focus more on borrower credit and property cash flow and less about the borrower’s personal income. In a lot of ways these loans are considered “low” or “no doc” as compared to a more traditional conventional loan. The process and documentation requirements for DSCR loans are much less. 

Another benefit of a DSCR loan is that many lenders will allow borrowers to purchase properties in the name of an LLC or corporation which is typically something that conventional lenders will not allow. This is highly beneficial to investors as holding a property in an LLC has potential tax benefits to the investor and reduces exposure from a liability standpoint. 

Conventional loans for real estate investors

What is a conventional loan? A “conventional” or “conforming” loan is simply a mortgage that is not a government loan and is not backed by FHA, VA or USDA. Most conventional loans are originated and underwritten by private lenders. Upon loan funding, these loans are then typically sold to Fannie Mae or Freddie Mac who operate in the secondary mortgage market. Fannie and Freddie then package these loans as mortgage backed securities (MBS) and sell these MBS’s to investors around the world.

Since these loans are sold to Fannie and Freddie there are very specific underwriting guidelines that each loan needs to meet. Income, assets, credit and collateral are all carefully reviewed to make sure that each loan meets proper guidelines and is a loan that will be “saleable” to Fannie or Freddie. 

As a result of these specific guidelines it is often difficult for real estate investors to qualify for conventional mortgages. Often, real estate investors have multiple properties and different businesses or LLC’s and if any of these businesses show losses they may not meet Fannie or Freddie eligibility. 

Another restriction of conventional lending for investors is that Fannie and Freddie do not allow investors to buy properties in the name of an LLC and they also have a restriction on how many investment properties one person can own.

The main benefit of conventional loans for investors is that if you are able to qualify you will most likely get an interest rate that is lower and more competitive than an DSCR loan. However, it will be a much more time consuming and difficult process for the borrower to get the loan approved.

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