DSCR loans, we hear you, we see you, everyone's talking about them. They seem like the cure for everything. Are DSCR loans the one ring to rule them all, or are they just another option in a suite of loan packages that could all work for you? You will know this and more after listening to today's episode of Mortgage Monday.
Christian Bassador, my partner and broker in The One Brokerage, is here with me today. How are you, Christian?
Christian: Good to be here today.
Today, we are going to give the people what they want. People have been asking about DSCR. They speak about it like it's an elusive unicorn. We are going to break down how they can catch themselves a unicorn, as well as some of the misconceptions and how people can know if this loan is right for them.
Side note: Before we even get into this, have you noticed an increasing number of people who are showing up to loan officers telling the loan officer, "This is the loan I want," rather than asking, "What loan would be better for me?"
Christian: Absolutely, and this is the product that happens the most with. I think there's kind of a veil of mystery around the DSCR loan. It kind of seems like it's the secret sauce, the magic Juju to get me a loan when I don't qualify otherwise. You know, and it's not the best fit for everybody. It is a very powerful loan product that allows you to scale your portfolio, but a consultation with a loan officer is always the first advisable step.
Yeah, because when they come to us and ask for a DSCR loan, we ask questions and realize, "Hey, this one would be cheaper. You don't need to use the DSCR." Or, "Yeah, this is better than nothing and it's better than a five-year balloon payment." But there are pros and cons to everything.
Let's start off by just describing what does DSCR stand for and how is it different than conventional underwriting?
Christian: Yeah, this is going to be a good video, guys, for you to bookmark and come back and watch later at any point in time, multiple times, just to understand this loan product because there's so much information out, and there's a lot of conflicting information.
DSCR, to answer your question, David, stands for Debt Service Coverage Ratio. It's a bunch of fancy words that don't mean anything unless you understand it. All that means is a ratio, obviously, a ratio of two numbers, and that's going to be your rents over your debts. It's an easy way to think about it, right? So if you have a property that rents for a thousand a month and your mortgage is 750 a month, you have a cash flow positive property. Right? And that mortgage has to include your PITI. Now, a lot of people may ask, "What about the utilities? What about the maintenance? What about capex?" All those other things Bigger Pockets sold me. That's all well and good. You should put that in your calculators, but it is not how they calculate the ratio that qualifies you for the loan. All they care about is your gross rents over your gross liabilities, including principal, interest, taxes, and insurance.
And it's not a revolutionary concept. We have been valuing commercial loans with this very same ratio for as long as I've been investing. What's revolutionary is that now there are loans that you can use with the same structure for residential real estate. It was never this way. You always had to qualify to buy residential real estate by your own debt-to-income ratio, which created a host of problems because once you've got a whole lot of real estate, you've got a whole lot of debt, and that means your income has to continue to grow with it, and it becomes hard to keep qualifying with every single house. The next one becomes harder. But with DSCR ratios, that's not the case. The better you buy, the better you are when it comes to the loan. It actually is a way of sort of built-in protecting the lender against default because they're making sure that the property can pay for itself.
One of the detriments of DSCR financing in commercial real estate was that you never got a 30-year fixed-rate mortgage. You got maybe a 20 or 25-year amortization schedule with a five-year balloon payment. You are constantly having to refi these properties. You never knew what your interest rate was going to be three to five years in the future. But that's not the case with some of these DSCR loans now. So tell me about what people can expect if they do go the DSCR route on residential real estate.
Christian: Yeah, I'd say three main options with the DSCR loan.
Alright. And then there's also a prepayment, right? Can you explain what a prepayment penalty is and how it works on these loans?
Christian: Yeah, almost all DSCR loan products are going to have a prepayment option. What I mean by that is it's zero to five years, typically, with most lenders. And what that means is that if you refinance or sell that property, anything that leads to you paying off that mortgage in that time period, zero to five years, there's going to be a fee attached. Sometimes it's two, three, four percent of the loan, sometimes it's six months of interest payments. Regardless of what it is, there is a fee, is the important thing to know.
What a lot of people don't know is that it's customizable, which means if you have a two-year holding period that you know you're only going to hold this property for two years and then kick that money into some other project, we're going to buy down your prepayment penalty to two years.
Now, what do I mean by buy down? If the best pricing for DSCR loans is at a five-year prepay, you're taking the absolute maximum prepayment penalty. You're guaranteeing to the lender you're going to hold onto it for five years, you're going to get the best rate. Now, if you buy it down to any iteration of four, three, two, one, zero, you can do that, but you're going to have a higher rate or higher points, closing costs upfront. That's where we can custom tailor the product to you. We can pay a little bit of money upfront or have a little bit higher rate to save you the exit fees on the prepay. And that's just where having that honest communication with your loan officer of what your plan is for the property or if you just want to have the opportunity to refinance with no prepayment penalty in two or three years, whether you choose to do it or not, we can structure that into your loan.
Perfect. Now, why do these lenders add these prepayment penalties on DSCR loans when they don't do this on conventional loans?
Christian: Yeah, it's a good question. Well, in most cases, these DSCR loans, they're done... I don't want to say they're more risky, but they are more than conventional loans where debt-to-income is calculated and all that. Basically, lenders are trying to guarantee that you will hold their loan for a specific period of time so that they can actually make money giving these loans. If they were giving money out and getting payoffs in six months, they aren't actually collecting any money. It's very little fees actually coming to them. So by holding these prepayment funds, you remember DSCR loans are not a government-backed loan, they're not a Fannie Mae or a Freddie Mac product where they could just go and sell this to mortgage-backed securities and get these bundled to investors. These have very niche buyers.
So to hold the value of the loan, they want to make sure that there is a certain guaranteed period that they will be collecting income from. But that means, in layman's terms, a Freddie Mac or a Fannie Mae loan are government-sponsored entities that say, "Hey, if you as a lender write your loan to conform to these guidelines, we will buy them from you once you've originated them." So the lender knows, "Alright, I'm going to get my money back after I give it to Christian to buy his house so that I can go lend it to the next person," which makes them easy to sell. And then they get sold through a series of... it's almost like a stamp of approval, right?
Yeah, like the seal of approval means it's a good loan, so more people are willing to buy it. So it changes hands more frequently and ends up in basically the stock market, is what you call the mortgage-backed security. It's very easy to sell that loan when it's that way. The DSCR loans do not take that same path. They are done by private individuals. The government is not involved with that, there's no guarantee on it, so it can be tougher to sell, which means they need to hold it for a longer period of time before they can get a break-even point where they get the money back that they let you borrow. Is that a fair assessment?
Christian: Yeah, yeah, that's hit the nail on the head. So there is a penalty when you go this road that there's going to be a prepayment penalty, you don't get that with conventional loans.
The other way that they're usually not going to be as advantageous as conventional financing is the rate itself. What do you see in the difference between a typical 30-year fixed rate on conventional versus DSCR?
Christian: Yeah, typically, depending on credit scores, we're about one to one and a half percent on the rate difference. So if conventional is at seven, you're probably eight to eight and a half, and that's typically where most DSCRs will land. Now, that can vary and fluctuate by the day, but that's just for a general rule of thumb that seems to be a pretty fair estimation.
Now, there's so much conflicting information about DSCR loans. Some people say this, some people say that. How much of this is lies? How much of it is truth? And how much of it is just that there's a lot of variability in this product because it doesn't fit within that pipeline of conventional financing like we mentioned?
Christian: Yeah, this is something that even I'm guilty of at certain points in time. I remember back when we were doing short-term rentals and we were doing short-term rental DSCR loans at 15% down, and we did have a single lender doing that. Nowadays, that's not the case. Now, everything requires 20 to 25%. They've given up that 15% option. But why you hear so much different information is not that some people are lying to you, it's that when you're in the conventional space, which most brokers and most lenders historically have been, there's very defined, rigid rules. There's a defined debt-to-income you can go to, there's a defined credit score you can accept, there's a defined amount of income this property can generate that is defined, right? Everything is known. We know how to analyze somebody's credit score.
With DSCR loans, they're so, I don't want to say new, but they're so flexible that each of these lenders, and I mean, just us as a broker, we have over 75 DSCR lenders in our network. That means we have 75 different sets of information that we have to memorize. So when you hear somebody say, "You can use short-term rental income to qualify," that is correct. But if you go to another broker and get a quote for a DSCR loan, it might beat us. They're not going to be able to use short-term rental income, right? They're going to use that long-term. So if you're going and buying a property in the Smokies that rents for $2,000 a month on a 12-month lease, but it really rents for nine grand a month on a short-term rental, your other lender is going to use that 2 grand and you're not going to qualify for that loan, whereas if you come to us, we'll be able to use that 9 grand. But it's comparing different products, right? Because every lender that does DSCR financing has their own set of criteria that they use and their own exceptions that they'll allow.
Yeah, it's like Fannie Mae version one through fifty, right? Like they all have their own underwriting criteria. So when you hear somebody like myself, another broker, whoever you guys are listening to, talk about non-conventional loan products, keep in mind typically it's general advice that is a collection of what most DSCR lenders accept in the industry. But when you actually go to get a qualification, we may not be able to package them together, for instance, right? You may have to put 25% down to buy a multi-family. It may have to cash flow 1.1 if it's a short-term rental, right? Instead of just one, even all these little things, you guys don't have to memorize these. I'm just using it as an example to say DSCR loans are constantly in flux, and there's so many different institutions that are offering it right now. Let that be our job of placing you with the right one. When we place you with one, make sure you know that, "Hey, we probably went and got an exception for this." Right? Like David, you and Rob realized on your house in Scottsdale that there was an acreage limit, right?
Right, like DSCR loans, didn't want to lend on a seven-acre property, or however many acres your property is. A seven-acre property or whatever it is, that's something that unless a broker has encountered that and gone through that, they're not going to know, and they're just gonna go give you a rate quote. They're going to give up easy. They're gonna get told no. They can't do it, and that's what you're gonna hear. They're not going to fight their way to the top of that company and say, 'Well, what would it take for you to do the loan?' That's what we do. We got an exception, right? And that's something that conventional lending, there's no such thing as exceptions, right?
In non-QM lending, depending on the relationship your broker has with the lender, a lot of times you can get things through just based on good communication and good documentation that otherwise you wouldn't be able to. In your case, in Scottsdale, the cash flow and the quality of that property were so high that the lender was willing to say, 'Okay, we'll accept the acreage limit.' But we had to fight for that. That was a denial, you know? Day one, we had to fight to get it to an approval.
Yeah, that's a really good point. You're also making me remember part of the reason that he and I got that house at the price we did was it sat on the market for an exceptionally long period of time for a property of that quality. It sounded like it was on there for a year, but literally, the land that we bought is worth more than the land with the house on it. It should have sold for so much more, and the reason was all the other people that were trying to buy it were trying to use conventional financing, and they hit that acreage limit where the lender said no. We will not lend on an area that has this much acreage because there's a rule that basically lenders are protecting themselves. If they have to foreclose, they don't want to take a bunch of land, and they assume that if it's a little house on a big area of land, the majority of the value is in the land, not the house, and it would be harder for them to sell.
But we were able to get it for what we did because you were able to find a lender that would let us use a DSCR loan to buy the house and made an exception. So we paid, I mean, close to half of what that probably would have cost if they could have gotten conventional financing based on what the other houses listed for, which is, you know, several million dollars of equity right off the bat because we had lenders that would go fight. So this is one of the ways that DSCR can come in handy.
But I love what you said earlier. It's not a de facto 'just go do this.' It's something you have to go ask your loan officer. Here's what I'm intending to do. Would DSCR work better or would conventional work better? And let them work through the process.
Maybe they don't accept short-term rentals. Maybe they wouldn't accept seven acres. Maybe they wouldn't accept a three and a half million dollar loan amount. You know, all of these things, when you start bundling them together, once again, going to a single-name DSCR lender versus a broker is the same thing as going to Chase to get a loan, right? They can only offer you the Chase guidelines with all the Chase overlays, all the Chase underwriting, whereas a broker can say, like what we did with David and Rob, 'Oh, you need short-term income projections to be qualifying. Okay, we also need a high acreage exception. Okay, we also want to put down 15 or 20 percent instead of 30,' which is where a lot of other lenders wanted us to put 30 down for you guys, right?
We also need it to be whatever, right? All these little things that we had to piece together, we had to find a lender in our huge database that would accept all of those key points, right? Not just one of them, not just two of them, and not just somebody who would have the lowest rate but couldn't get you the loan, right? It's like a game of Tetris playing these puzzle pieces together sometimes, but that's our job. But the advantage is when the broker does a lot of business, they can get right to the CEO of the company. I think I've heard you and a few other people say in order to get my loan closed, you went to the CEO and said many times what we need to get this thing done, and they said, 'Okay, we'll make the exception.' Well, when we do 80 loans a month with that person, we have a little bit more leverage than if you don't, right? And that's why going to a lender who has a good reputation, that's good at what they do, they will frequently be able to make that thing work for you that wouldn't work if you're just shopping around and saying, 'What's your rate? What's your rate? What's your rate?' You end up with the person who does hardly any loans at all. They're willing to cut their rate just because they need a closing, but then you find out, 'Oh, you can't make the deal work.'
I remember for a long time, I don't know that there was another lender that could use short-term rental income projections to qualify for a DSCR loan. Yeah, so some of these like $800,000 cabins or $900,000 beach houses, they might rent for $4,500 a month on Rentometer, which is what the DSCR lenders would use, but we're like, 'No, it's going to be $11,000 a month in short-term rental income. This will cash flow.' And we were able to get our clients closed on those deals. We saved so many deals because of that product right there. So many. I mean, myself included. I mean, I bought my cabins on DSCR loans, and they wouldn't have qualified if we had to use long-term rents, right?
And I think a lot of people just get told no from their lender, and they don't realize there's another option. There's people out there that can do it if they know where to go.
So if people do want to talk to you, if they just want a brokerage that they could go to for everything, the one brokerage that they can get to do it all, where can they go to find out more about you? How can they contact you? And what would you advise them to do?"
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