Published in January, DSCR Loans – Get The Best Deal! proved to be a popular rundown on DSCR Loans, a loan product increasingly used by more and more real estate investors to scale their portfolios. DSCR Loans are best known for easy qualification and light documentation standards (no income verification, no DTI, no tax returns). Sophisticated real estate investors keep turning to DSCR loans after maxing out on conventional financing options. Some are finding that its simply not worth trading the time and hassle of bank qualifying for the slightly lower rates.
The previous article outlined the basics of how DSCR loan borrowers can secure the best rates and terms. Quick recap: the rates and terms are primarily driven by three main metrics: 1) Loan-To-Value (“LTV”) Ratio, or the ratio of your loan to the value of the property, 2) Debt-Service-Coverage-Ratio (“DSCR”) Ratio, or the ratio of the properties rental income to its PITIA expenses and 3) FICO – or personal credit score.
While your quoted rate is mainly driven by those three factors, several other pieces to the puzzle affect terms as well. The savvy DSCR loan borrower will use all the options available to optimize terms. Especially in volatile rate environments like today, every little bit of rate matters in securing profitable investments! This article will walk through the more advanced strategies real estate investors can use to minimize their rates on DSCR loans and secure the best long-term financing for their portfolios.
Prepayment Penalties
The best way to get the lowest-rate DSCR loan is to allow the lender to place prepayment penalty provisions in the loan. Essentially, this means that for the first few years of the term, if you prepay the loan early by either selling or refinancing, you’ll have to pay a fee equal to a low percentage of the outstanding loan amount. DSCR loans are pretty much universally 30-year loans and the prepayment penalty percentage typically ranges somewhere between 1-5%.
If your DSCR loan contains a prepayment penalty, then your rate can generally be significantly lower. Depending on the structure of the prepayment penalty (length + percentage), your rate could be a full 100 basis points (1.00%) lower, or more! Why are DSCR lenders willing to give you much better rates if there is a prepayment penalty? Its because most DSCR loans are securitized, or pooled into mortgage bonds for investors such as pension funds or insurance companies that rely on consistent and predictable cash flows – which would be jeopardized if too many loans prepay too quickly.
Prepayment Penalty structure options vary from lender to lender. The most common are “stepdown” structures. A “5/4/3/2/1” structure, for example, means that if prepaid during the first 12 monthly payment dates – the fee is 5%, if prepaid during the next 12 monthly payment dates the fee is 4% and so on – with no fees applied if the loan is prepaid anytime during the last 25 years of the 30-year term. This structure can be shortened with penalties lowered such as “3/2/1” or “2/1” options – with the same general concept. There are additional structures that are a bit harsher (compared to stepdowns), like a fixed 5% penalty for five years. This structure, however, is generally repaid handsomely by the lender with lower rates! Many lenders will be flexible around customizing these structures. Typically, lenders limit any prepayment penalty to 5% and any penalty period to no more than five years.
Strategically Select Your Prepay Structure
So how do you take advantage of prepayment penalties as a DSCR borrower? The good news is that DSCR loans are made for investors with long time horizons with portfolios geared towards holding properties long-term to earn cash flow and appreciation. Thus, if you are a typical investor using DSCR loans to build a cash-flowing “financial freedom” portfolio, you probably aren’t planning on selling properties within the five-year window. Slapping on prepayment protection (that likely won’t affect you) is a great lever to pull!
What about refinancing if rates decrease? Prepayment penalties may hurt if rates decrease over the first few years of your loan and you’re looking to refinance. The penalty amount, however, is typically small enough so that refinancing would still be a good economic decision. According to the FHFA – since 2000, the average annual home price appreciation has been 4.7% – so if rates do indeed fall, your 1-5% prepayment penalty will likely be more than offset by your lowered rate and potential cash-out equity from an increased value!
DSCR Loan Structure: Fixed Rate vs. ARM
Another advanced option for real estate investors utilizing DSCR loans is using an ARM (Adjustable Rate Mortgage) option. However, it is extremely important to understand this structure and all the nuances because it can be confusing if you don’t do your research. Furthermore, there is a lot of confusion and misunderstanding surrounding ARMs. The ARM options today for DSCR loans are markedly different than some of the ARM structures of the early 2000s that helped facilitate the mortgage meltdown of 2008.
Quick overview on ARM DSCR Loans:
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- Sometimes referred to as “5-Year ARMs” or “7-Year ARMS” – these are still thirty-year mortgage loans. The number for an ARM typically refers to the initial fixed-rate term rather than the full term.
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- Unlike early 2000s ARMS which started floating quickly, DSCR ARMs are more of a hybrid product. After the fixed period (typically first five or seven years), the rate floats.
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- These are typically expressed as two numbers separated by a slash – such as “5/1” or “7/6”. The first number is the initial years of the term for which the rate is fixed. The second number refers to the frequency of rate adjustments after the fixed rate period. Note, this part is confusing – “6” refers to floating every six months, “1” refers to floating every one year. Confusing (or poorly structured industry-standard terminology) is another reason its very important to really make sure you understand your terms and structure if going with an ARM DSCR loan!
ARM DSCR loans contain provisions for determining the interest rate after the initial fixed rate period. The rate typically converts to a number that is equal to a pre-determined “margin” and an index number. Common benchmark interest rates include SOFR (Secured Overnight Financing Rate) and LIBOR (London Interbank Offered Rate). Additionally, the floating rate is subject to a floor (typically your initial fixed rate) it can never go below, a ceiling (typically your initial fixed rate plus five or six percent) it can never go above, as well as periodic rate adjustment caps to prevent rate shocks or huge changes in rate in a single payment date.
So how to take advantage of ARM options as a DSCR borrower? Typically, ARMs come with a lower rate than a 30-year fixed rate loan. Rates on ARM options are roughly 12.5-37.5bps lower than their 30-year fixed rate counterparts right now. This can be worth it depending on your risk tolerance, general outlook and personal investment plans and goals. If you are confident rates will be lower or stable in a five-year time frame (most economists have this view), then it can be a smart move. Remember from the section above, prepayment penalties will not last more than five years. There are no prepayment fees when refinancing a DSCR loan after the initial fixed rate period.
Long-Term Rental Rents Qualification vs. Short Term Rental
The biggest trend in real estate the last few years has been investors turning to short term rentals vs. long-term rentals, primarily for the significant difference in cash flow and profitability (STRs generally earn twice as much as long-term rentals). However, many DSCR lenders view Short Term Rentals as more risky. They view STRs as prone to disruptions in cash flow and viability due to dependency on the greater economy, seasonality, regulatory risk and costs and sophistication to operate well.
The current trend among DSCR lenders is to either stop lending on Short Term Rental properties. Many lenders have started to qualify these properties based only on how they would perform as a long-term rental, or just charge higher rates if the property is an STR. A good strategy for an investor wanting to stick with STRs is to pick properties in markets that cash-flow if used as a long-term or short-term rental. This allows the lender to generate the rate consistent with a “safer” long-term rental property, likely to be significantly lower.
Strategic LLCs and Entity Structures
The final advanced strategy we’ll cover for getting the best rates/terms is strategically structuring the borrowing entity to maximize credit. One of the key advantages to DSCR loans is the ability to borrow though an entity such as an LLC. While there are pitfalls to avoid, investing with a partner or partners that have complementary skillsets is a tried and true recipe for successful real estate investing.
As discussed in the original article, Credit Score is one of the main three factors for determining rates and terms. The “qualifying credit score” used to generate your rate can vary depending on the lender if a borrowing entity has multiple owners. Let’s take an LLC owned 50/50 between two parties, for example. Some DSCR lenders will use the lower of the two median scores while some will use the higher. Strategic ownership structures limiting inexperienced or poor credit borrowers to no more than 25% ownership won’t negatively affect qualification. Most lenders will not pull credit for these members with minority ownership percentages. Note – Do Not cross the line between strategic entity structure and “straw borrowers.” Placing otherwise disinterested parties as part of LLCs and loan guarantors just for credit qualification risks potential legal trouble for mortgage fraud!
EasyRent: The Professional Investor’s Choice for DSCR Loans
DSCR loans are increasing in popularity because of their flexibility in comparison to the standardized requirements of conventional financing. The ability to customize DSCR loans to fit each unique deal is mutually beneficial for borrowers and lenders. This paves the way for win-win loans and long-term relationships.
Searching for a lender with the most relevant options for the strategies outlined above? Look no further than Easy Street Capital! Our EasyRent DSCR Loan Program is tailored to meet the needs of the modern real estate investor and is regularly updated to meet market needs. Whether you’re using the BRRRR method, scaling an STR portfolio, a seasoned pro, or even a first-time investor, we’ve got the perfect loan for your situation!
The Easy Street Advantage
Prepayment Penalty Options
EasyRent’s prepayment penalties range from a 5-year, 5% fixed penalty all the way down to no prepayment penalty at all. Each deal is unique, we strive to accommodate the best possible prepayment penalty for your specific situation. Are you looking to lock in the lowest possible rate with a property that already has strong cashflows? The 5×5 is your best option. Exploring refinancing opportunities within the next five years and want to keep your choices open? Take advantage of our no prepay option!
DSCR Loan Structure
In terms of structure, we offer 30-yr fixed rate mortgages as well as ARMs. Both structures can be fully amortizing or partial interest-only (first 10 years). While the majority of our borrowers opt for a fully amortizing, 30-yr fixed rate mortgage, we have recently seen an uptick in borrowers exploring our alternative options.
Let’s say you purchase an investment property with the intent to refinance some time within the first 10 years. By taking advantage of our interest-only option, you would be saving yourself a good chunk of change. The first 10 years of our IO loans are, as you can probably guess, interest-only payments – notably lower monthly payments when compared to a fully amortizing loan for the same situation. The remaining 20 years of payments are inclusive of both interest and principal, amortizing on a 20 year schedule. This means higher monthly payments for the last 20 years of the loan to maturity. If you refinance some time in the first 10 years, you can avoid the last 20 years of higher payments!
Income Qualification: LTR vs. STR
Short Term Rentals are our specialty. EasyRent is an industry leader when it comes to short term rental underwriting. We recognize the value and opportunity that comes with these properties. With tightening restrictions imminent on short term rentals, many lenders have ceased financing STRs. Or if still financing STRs, they charge much higher rates if the property doesn’t cash flow with long term rents. In addition to charging higher rates, most other lenders still lending on short term rentals will place leverage or market restrictions as well. We remain steadfast in our commitment to financing short term rentals. The modern STR sector is still in its infancy in relation to the rest of the industry. Easy Street is still lending max leverage (80.0% LTV) and in all markets (tertiary, rural included) for short term rental DSCR loans.
Entity Structure
When it comes to qualifying credit score, EasyRent will use the highest median FICO score of all guarantors. Guarantors on an EasyRent loan must still hold a credit score of at least 620, however. We are open to almost every entity structure – from LLCs, to corporations, to partnerships, to inter-vivos revocable trusts. Borrowing through an LLC managed by a corporation controlled by a general partnership with an inter-vivos revocable trust as the general partner? That’s okay too! We generally encourage our borrowers to vest the loan to an entity to mitigate risk and liability for their sake.
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