Getting turned down for a mortgage not only delays the home purchase process but could also have a slight impact on your credit score. 

So it is crucial to understand all the requirements you need to qualify for a mortgage. 

One of them is the debt service category ratio (DSCR), an important metric that measures a company or individual's ability to service its debt obligations. 

This article will provide an overview of DSCR and how it works. Whether you are a new business owner, an established entrepreneur, or just a curious reader, this article explains why this metric is important and how lenders use it.

TLDR Key Takeaways

• DSCR measures whether a company's operating income will cover all its debt-related obligations in a single year.
• Positive cash flow is a value above 1.0. Lenders, however, usually want a buffer to protect against unexpected revenue declines.
• There is no particular requirement for all borrowers, but most lenders prefer a DSCR of 1.20 - 1.25. 

What is Debt Service Coverage Ratio?

Debt service coverage ratio measures whether a company's operating income will cover all its debt-related obligations in a single year. 

As part of debt servicing, interest and a portion of the principal must be paid annually. It also includes previously agreed-upon lease payments. 

The DSCR analyzes financial statements and estimates cash flow for businesses or investment properties.

Aside from getting insights into financing options, the debt service coverage ratio is a valuable tool for real estate investors to compare properties before investing in them.

How DSCR Affects Your Mortgage

DSCR measures the ability of an individual or a business to pay their debts with their net operating income (NOI). 

Lenders use the debt service coverage ratio to determine the maximum loan amount whenever the borrower takes out a new loan or refinances an existing mortgage. 

A higher DSCR ratio indicates that there is more available net operating income to service debt.

So, for instance, if a borrower's DSCR is 0.90, there will only be enough net operating income to pay 90% of debts each year. 

In this case, the borrower would have to dip into their own funds or keep borrowing every month to keep the business afloat. 

Although lenders are generally reluctant to lend on negative cash flow, some do so if the borrower also has other reliable financial resources.

How to Calculate Your Debt Service Coverage Ratio

To calculate your debt service coverage ratio, divide your annual net operating income by your annual debt. 

The net operating income of an income-producing property is its profitability before any financing costs or taxes are included.

To calculate NOI, subtract all property expenses from all revenue generated on the property.

So, the formula for DSCR is 

Net Operating Income ÷ Total Debt Service

Example

Suppose a borrower has a net operating income of $2,000,000 and a total debt service of $350,000; their debt service coverage ratio will be:

2,000,000 ÷ 350,000

DSCR = 5.71

A DSCR of 5.71 means that the business seeking the loan can cover its debt payments more than five times over with the current level of operating income. So they are highly likely to qualify for a mortgage. 

What is a Good DSCR?

A debt service coverage ratio of 1.0 is the break-even point. So if the analysis shows that a business or investment opportunity is below 1.0, meaning 0.99, or lower, they are officially operating at a loss. This means they won’t be able to afford the loan payment. 

Anything above 1.0 shows positive cash flow. However, lenders typically want some kind of cushion in place, just in case a business or individual experiences a sudden drop in income. 

The amount of cushion depends on the business, the lender's risk tolerance, the overall health of the economy, and a host of other factors. 

There is no particular requirement for all borrowers, but most lenders prefer a DSCR of 1.20 - 1.25. 

A business with a DSCR of 1.5 or higher is typically perceived as really good and may have a case for obtaining better rates on their loan, depending on what the lender is willing to offer.

Quick Tips to Improve Your DSCR

The higher your debt service coverage ratio, the higher your chance of securing a mortgage. Follow these tips to improve your DSCR.

1. Increase Your Revenue

You can increase your revenue through sales growth and expanding into new markets. 

With more significant profits, you can increase cash flow, which will help meet debt payments and improve DSCR.

2. Reduce Debt

Taking steps like paying off high-interest credit cards, consolidating loans, and making larger payments can help reduce your outstanding debts and DSCR. 

It is also a good idea to consider refinancing if you qualify for lower interest rates or longer terms. Both options can make repayments easier and potentially save money in the long run. 

3. Take an Interest Only Loan

Interest-only loans relieve you of principal payments, boosting your DSCR. Lenders may, however, consider principal fees in their DSCR calculations when underwriting a loan.

4. Increase Amortization Period

Consider a 15-year loan if your DSCR is too low for a 10-year loan. You can lower your monthly principal payments and raise your DSCR. Although it increases the loan's total cost.

Increase Your Odds With Modern Day Lending

Debit service category ratio plays a crucial role in the outcome of your loan application because it helps lenders understand your ability to repay a loan. It also lets you have a clearer picture of your financial position. 

While there is no industry standard for DSCR rating, businesses and individuals with a higher score have a better chance of getting approved for a mortgage.

Are you a freelancer or entrepreneur looking for a mortgage? At Modern Day Lending, we help you improve the odds of getting approved. 

Our 20 years of experience and vast vast network of investors and financial institutions enable us to get you the financing you need at the best terms possible.

Schedule a consultation with us today!

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