What Is a Debt Service Coverage Ratio Mortgage?

Real estate investors have long turned to private money loans when conventional mortgage lenders have determined that either they, with their multiple property holdings, or the properties they are looking to buy, pose too great a risk. But for its benefits of closing quickly and not involving an intrusive qualifying process based on ability-to-repay (ATR), hard money loans are expensive and most often have terms that require the investor to refinance or pay off the loan in the short term — not an ideal fit for those who own, or are building, a portfolio of rental properties and who are looking to stabilize their cash flow. Enter the DSCR or “debt service coverage ratio” mortgage. This unique program seeks to provide the investor with a way to qualify for the mortgage without focusing on personal tax returns and debt-to-income (DTI) ratios. These are conventional loans that look more at the property than the borrower — almost like a commercial or private money loan — but with the added benefit of more appealing terms.

Our DSCR or “DCR” (debt coverage ratio) mortgage is designed for borrowers who are experienced real estate investors looking to purchase or refinance an investment property that is held for business purposes. We qualify these borrowers based upon the cash-flow of the subject property and they are not required to provide additional employment or income related information — let’s emphasize this again.  We are focusing on qualifying the property above the borrower. So where, in a traditional mortgage for a primary home, for example, we would be calculating debt-to-income based on the borrower’s paystubs and tax returns, and liabilities that carry over from the credit report, here we are looking at the cash flow of the property instead. Let’s dig in a little deeper.

Qualifying with Debt Coverage Ratio

The debt coverage ratio is calculated by taking 100% of the gross rents divided by the total monthly housing payment (PITIA) of the subject property. If a lease is in place on the subject property, we’ll use that number (with some exceptions) but if a lease is not in place, we’ll defer to the appraiser’s rent schedule. In order to qualify, our property must produce a DSCR ratio of greater than 1.0. So for example:

Property 1

  • Gross Rents = $3000
  • PITIA = $2800
  • Formula to determine DSCR: $3000 / $2800 = 1.07
  • A 1.07 DCR is greater than the 1.0 requirement to qualify, so this property is eligible for approval.

Property 2

  • Gross Rents = $1900
  • PITIA = $2250
  • Formula to determine DSCR: $1900 / $2250 = .84
  • Our DCR is .84 under the 1.0 requirement to qualify, so this property is NOT eligible for approval.

Both fixed rate and ARM programs are available to the investor on a DSCR qualification basis and this further expands the benefit of this qualification method. For those who own multiple investment properties and may not fit the qualifying criteria for a qualified mortgage (QM), the debt service coverage ratio alternative may be the solution you’ve been looking for. We’re here to help and answer any questions regarding your rental properties.

Come on in and cover me, 

 

Robert J. Spinosa
Vice President of Mortgage Lending
Guaranteed Rate
NMLS: 22343
Cell/Text: 415-367-5959
rob.spinosa@rate.com

Marin Office: 324 Sir Francis Drake Blvd., San Anselmo, CA 94960
Berkeley Office: 1400 Shattuck Ave., Suite 1, Berkeley, CA 94709

*The views and opinions expressed on this site about work-related matters are my own, have not been reviewed or approved by Guaranteed Rate and do not necessarily represent the views and opinions of Guaranteed Rate. In no way do I commit Guaranteed Rate to any position on any matter or issue without the express prior written consent of Guaranteed Rate’s Human Resources Department.

Guaranteed Rate. Illinois Residential Mortgage Licensee NMLS License #2611 3940 N. Ravenswood Chicago, IL 60613 – (866) 934-7283

Rental Income from Accessory Units. Hot or Not?

I don’t know about where you live, but here in Marin County, accessory dwelling units (“ADU”), also known as accessories, 1+’s, granny units, in-law’s, mother-in-law’s, etc., are all the rage. When we discuss remodel projects with our clients, adding an accessory is often high on the list. After all, if permitting allows, the thought of having the extra space to accommodate guests, parents or children, short- or long-term renters or maybe just create the proverbial doghouse in marriage under the strain of any/all of the above, can be appealing. But from a mortgage guideline standpoint, if you have or build an ADU, can you use the rental income it may generate in order to help you qualify for a home loan?

Get in the Zone

In order to answer our question about qualifying income, we have to address two key elements first:

  1. What is the legal description of the home?
  2. What type of loan are you seeking to obtain?

Let’s take a look at the first question from both the angle of the legal description of the property and also the method by which an appraiser might likely approach the opinion of value. It’s safe to say that if the property was built as a single family dwelling (SFD or SFR — for “residence”), adding an ADU will not change that. Usually the footprints of the structures will be sufficiently different such that the property would always be viewed as an SFD. When a second structure is built on one lot, per zoning requirements of course, and that home becomes a true second residence (different address, different utility meters, etc.), now we may be looking at a legal duplex instead. But for the scope of our conversation, let’s stick to the 1+ scenario. When an appraiser is hired to complete a report on an SFR with an accessory, he or she will check a box on the report that shows the property is a “1+” and the report will be done on a 1004 form (as opposed to the appraisal form 1025, which is used for 2, 3 and 4 units).

Now traditionally, if you have sought a mortgage for a legal 1-unit property, even with an accessory, and that home was your primary residence, lenders would NOT allow you to use the rental income in the qualification process. Boarder income (room rents), short-term rentals (AirBnB, VRBO, etc.) and even rents resulting from legitimate lease agreements on an ADU were a dead-end. This proved problematic for both buyers and owners of these properties because often the ADU, and its income-producing properties, were important characteristics in the desirability of the home itself. Absent categorization of the property as a legal 2-unit, rental income was out and borrowers had to qualify with employment-based income primarily. To further the confusion, some buyers would think they were buying a duplex, which has a higher conforming loan limit, and base their down payment and other terms off of that assumption, only to have their hopes dashed when they learned the home is legally an SFR with an accessory. As with many things in the inherently complex world of real estate, the grey area could be vast and the consequences serious.

What’s Changed?

Conforming loan programs (save for HomeReady) still adhere to the approach above, but there are some very promising options for the use of rental income if you require a jumbo mortgage. For the most part, we have really strong options for the inclusion of rental income from an ADU with a number of jumbo investors. The gold standard tends to be that the rental income must have been declared on the borrower’s tax returns for the last two years. In short, a history is required to document stable income production from the ADU. Now as you might suspect, this is going to preclude a purchase loan, where the buyer would not be able to produce such a history. In that case, we have another investor that not only accommodates ADU income on a purchase, but will use an appraiser’s opinion of market rent for the unit (as opposed to requiring a lease agreement).

ADU, short-term rentals and boarder income are all a reality in many markets. And the trend appears to be increasing in terms of the popularity of these property and the financial benefits they can bestow to the owner/borrower. It’s also a fact that not all mortgage lenders have the programs that will take this income into consideration and have it work to the borrower’s advantage. We are one of the lenders who will and if you have any questions about the generation and use of the rental income from your one-unit, primary home, give me a call any time.

ADU 4 U n Me, 

 

Robert J. Spinosa
Vice President of Mortgage Lending
Guaranteed Rate
NMLS: 22343
Cell/Text: 415-367-5959
rob.spinosa@rate.com

Marin Office: 324 Sir Francis Drake Blvd., San Anselmo, CA 94960
Berkeley Office: 1400 Shattuck Ave., Suite 1, Berkeley, CA 94709

*The views and opinions expressed on this site about work-related matters are my own, have not been reviewed or approved by Guaranteed Rate and do not necessarily represent the views and opinions of Guaranteed Rate. In no way do I commit Guaranteed Rate to any position on any matter or issue without the express prior written consent of Guaranteed Rate’s Human Resources Department.

Guaranteed Rate. Illinois Residential Mortgage Licensee NMLS License #2611 3940 N. Ravenswood Chicago, IL 60613 – (866) 934-7283