DSCR Loan Interest-Only Strategic Financing

Cash flow makes or breaks DSCR loans. More cash flow creates more borrowing power.

But, to increase cash flow, you can charge only so much in rent. You can cut property management costs only so far.

What happens when you need more cash flow, to get DSCR loan approval, but you can’t find it?

For some investors, a DSCR loan with interest-only payments will help.

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How DSCR loans work

Credit scores and down payments matter, but DSCR — which stands for debt-service coverage ratio — undergirds your DSCR loan file.

DSCR compares two numbers:

• How much net income you earn each month from the property
• What you owe each month for the property’s loan payment

If these two numbers match, your DSCR is 1.0, meaning your property will earn exactly enough, in profit from rent, to cover the loan’s monthly payment. If your new property will earn more than enough to cover the loan payment, your DSCR will be above 1.0. DSCR lenders like that.

Ratios below 1.0 will worry many lenders. Lenders won’t be sure you can afford the payment. You could still get approved with a sub-1.0 DSCR, but you’d probably need a bigger down payment or a healthy savings account balance — some way to show you can make the loan payment in a pinch.

How IO can help DSCR loan eligibility

A lot of new investors who want to increase their cash flow focus only on one side of the DSCR equation — their earnings.

They’re not wrong. Charging more rent — enough to exceed the monthly loan payment on the property — will push their DSCR into plus territory. But charging more than market value for rent will make getting, and keeping, a tenant harder. This could undermine the entire project. After all, an empty home earns no rent.

The other way to raise DSCR focuses on the other side of the equation — the payment needed to keep the loan current. A lower monthly debt payment increases cash flow even when rental income stays the same.

A DSCR loan with interest-only payments is one way to lower your monthly payments — at least in the early years of the loan’s term. Some lenders call these IO DSCR or DSCR/IO loans.

The difference the interest-only option can make in your DSCR

An interest-only DSCR loan’s monthly payments cover only the annual interest charged on your loan balance. The principal of the loan — the actual amount you borrowed — will not decrease during the loan’s interest-only period.

Sometimes, an interest-only loan’s lower payments can create just enough in monthly savings to achieve DSCR eligibility.

Check out this example:

For this example, let’s say the lender needs a DSCR of 1.0 to approve the loan. (Remember, 1.0 is the break-even point, when rental income equals mortgage payment.)

As you can see, the payments on a 30-year fixed DSCR come a little higher than the home’s estimated rental income, meaning DSCR falls below 1.0, and the home is not DSCR-loan eligible.

But the same home’s lower, interest-only payments would fall just low enough to push the DSCR over the 1.0 threshold, meaning the home would become DSCR-loan eligible.

Refinance into an interest-only loan to improve cash flow

Sure, IO can help you buy a rental property, but it could also improve cash flow on an existing property.

In the above example, we saw that the IO option reduced the monthly payment on a $400,000 loan by about $200 per month. That could go a long way toward building a cushion in case of needed repairs, vacancy, or just to take as profit.

If cash flow is your ultimate goal, an interest-only DSCR refinance is something to consider.

Ask your DSCR lender upfront about interest-only loans

To find DSCR loans, real estate investors usually look beyond the traditional lending marketplace. There, they find alternative lenders who specialize in loans for investors.

Even in the alternative lending market, interest-only DSCRs are hard to find. Most of the lenders who underwrite DSCR loans do not advertise an interest-only DSCR option. But, if this type of loan could make a big difference for your portfolio, it’s worth asking about.

DSCR lenders already specialize in thinking outside the box; they excel at meeting borrowers where they are instead of looking for borrowers who fit the mold of an existing loan type. IO loans fit these values. 

In short, it never hurts to ask.

How to qualify for an interest-only DSCR loan

Qualifying for an IO DSCR will be much like qualifying for a typical DSCR loan. For starters, you’ll need to show your property’s signed lease agreement to the lender. This will show how much rent you can expect to earn from the property. Lenders can’t calculate DSCR without proof of rent.

Don’t worry if you don’t have a lease yet. The lender can use market rents in your area as a baseline. Even if you have a signed lease agreement, lenders will use market rents if they’re lower than the amount your tenant is paying.

Since interest-only loans are riskier for lenders, the lender may enforce stricter guidelines for an IO DSCR:

• Credit score: An IO DSCR may need a higher credit score — 680 instead of 640, for example
• Down payment: An IO loan may require more money down, too — a 30% down payment instead of 20% down, for example
• Other factors: Having enough cash in the bank to pay the loan for a year will help your eligibility. Showing you’ve succeeded as landlord with other properties will help too

Qualifying for a DSCR loan begins with a conversation with a loan officer about your specific needs. Even if you don’t meet every requirement, it’s OK to apply.      

How does an interest-only DSCR loan work?

An interest-only DSCR requires the borrower to pay only interest on the principal balance during the first months, or years, of the loan’s term.

The timeline for interest-only payments depends on the loan’s structure. For example, a 40-year DSCR with 10-year IO period charges only interest for the first 10 years of the loan. Only after the 10-year IO period expires will the loan balance start to decrease.

For example, let’s say you have a $350,000 DSCR loan. At 8% interest, you’d owe $28,000 a year in interest. That’s $2,333 a month.

At the end of the first 10 years, the lender would start adding principal to your payment. Paying principal and interest together would cost $2,568 a month for the next 30 years. 

Aren’t IO loans a bad idea?

Anyone who knows anything about borrowing money will tell you: Be careful with interest-only loans. These loans will save a little money at first, but they will cost a lot more money in the long run.

This is true. Keeping the $350,000 loan described above and making all its interest-only payments for 10 years would cost $280,000 in interest. And despite that hefty price tag, your principal balance, in 10 years, would still be $350,000. And you’d be paying another $574,742 in interest over the upcoming 30-year amortization schedule.

This is the very definition of a terrible idea, so why would an investor go down this path?

Short game vs long game

An investor who gets a DSCR interest-only loan knows interest depends on time. To overpay on interest, the investor would have to keep the loan long enough to pay too much.

Smart investors won’t do this. They’ll harness an IO loan’s lower initial payments to their advantage. Then they’ll get out of the loan before it has a chance to cost them. They’ll either refinance the loan, pay it off, or sell the home for a profit.

Smart investors also know a standard amortization schedule front-loads interest anyway, meaning they’re already paying next-to-nothing on principal during the first year of a 30-year loan. To them, paying no principal for a while isn’t much different from paying a tiny amount of principal for a while.

Used in this way, an interest-only DSCR can be a savvy idea, especially if it raises your DSCR into eligibility, making an investment possible.

Other ways to increase your DSCR

Of course, an interest-only loan isn’t the only way to raise your DSCR.  

You could also:

• Buy down your rate with discount points: Lower rate = lower payment = higher DSCR
• Buy a fixer-upper: Spending less for a home (then fixing it up to attract market rents) will raise DSCR
• Buy in an area with higher rents: In some places it costs more to rent than to buy. These areas are sweet spots for DSCR borrowers
• Cash for keys: Do the existing tenants pay less than market rent? You could pay them to exit the lease so you can charge market rent to the next tenant
• Stretch the loan’s term: Can you find a 40-year DSCR? It’ll require lower payments, raising DSCR
• Put more money down: Paying more upfront means you can borrow less, which creates smaller monthly payments — and a higher DSCR

IO loans can push DSCR into eligibility

Found a property with plenty of cash flow — more than enough to clear your lender’s minimum? You won’t need a DSCR loan with interest only payments.

But if your property straddles the fence — if it barely clears, or almost clears, your lender’s minimum DSCR threshold — an interest-only DSCR loan may push your file across the finish line.

For some investors, this type of loan will make a new investment possible.