A debt-service coverage ratio (DSCR) is a loan-to-value ratio that lenders use to determine whether to approve a loan. The DSCR is used to determine whether the borrower will be able to pay the loan back. A higher DSCR means the borrower will be able to pay back the loan in full and on time.
Lenders use the DSCR to get a better idea of how much money the borrower will have available to pay back the loan. They also use the DSCR to determine whether to approve the loan and for how much.
The DSCR is used when a lender wants to know if a borrower can repay a loan. The DSCR is based on the amount of money a borrower can borrow, which is called the loan amount. The amount borrowed is usually based on the amount of money the borrower can put toward the loan.
The amount of money available to pay back the loan is called the debt service coverage ratio. The DSCR is calculated as:
DSCR = Loan Amount / Debt Service Coverage Ratio = (Amount Borrowed)(Debt Service Coverage Ratio)
Note that the DSCR is not a ratio that is used by lenders. It is a calculation that lenders use to find out if they can lend money to a borrower. Lenders use two other ratios—the debt-to-income ratio and the debt-to-cash-flow ratio—to find out whether they can lend money.
The first step in calculating your DSCR is figuring out your loan amount. Your loan amount is the total amount borrowed and does not include your down payment. It also does not include any other costs, such as closing costs or prepaid interest, that you may owe. Closing costs and prepaid interest are therefore not included in your DSCR calculation.
To figure out your loan amount, multiply the following numbers together:
- Loan Amount (the amount borrowed)
- Down Payment (the amount you paid toward your down payment)
The result of this calculation is your loan amount. Most lenders use an interest rate of between 3% and 5% for loans with a down payment of between 3% and 5%. Lenders may charge you an origination fee of 1% or less, depending on your credit score. This origination fee is not included in your calculation.
The difference between increasing and decreasing your debt service coverage ratio is simple:
- Increasing your debt service coverage ratio means borrowing more money than you currently have available to pay back your loan.
Decreasing your debt service coverage ratio means borrowing less money than you currently have available to pay back your loan.
There are other factors that lenders consider when calculating your DSCR number. These include:
- The size of your down payment and credit score: Lenders will look at how much you put down toward your home purchase and how well you have paid for loans in the past. High credit scores and large down payments mean you will have less debt service coverage than someone with lower credit scores and smaller down payments.
The interest rate on your mortgage: Lenders will expect you to pay more in interest if you borrow more than you can afford to pay back. If you are able to borrow more than you can afford to pay back, it may be beneficial to borrow at a lower interest rate.
Your income: Lenders will look at how much money you made in the last year or so and how much money you make now, as well as how much you expect to make in the future. They will also consider how much money you spend on housing expenses and other living expenses, such as food and transportation, if you plan on moving out of your home loan or if you plan on moving in with family members or friends.
Your credit score: Lenders look at your credit score when deciding if they should give you credit at all. Lenders will also look at how much of your credit limit they will give you, based on your credit score. A higher credit score means that they will give you more credit than someone with a lower credit score.
Your debt-to-income ratio: This ratio is used to determine whether you can afford your new mortgage payment based on what percentage of your income you are paying for debt repayment, such as student loans or credit cards. A higher debt-to-income ratio means you have more available income for paying down debt, which means that you can more easily afford your monthly mortgage payment and other debts.
Your debt-to-cash-flow ratio: This ratio is used by lenders to determine whether they should give you credit at all because it reflects how much money you have available for paying off debt each month, including mortgage payments and other debts, such as credit cards, student loans, and car loans.
A higher debt-to-cash-flow ratio means that lenders will give you more credit than someone with a lower debt-to-cash-flow ratio because they know that you can afford to pay off your monthly debts with the cash that flows into your checking account each month.
A higher DSCR may not be an advantage for some borrowers because it could mean that the lender will lend less money than needed because they are overvaluing how much money they think you will be able to pay back each month.
In addition, if you borrow too much money, you may end up paying more interest than necessary because it takes time for borrowers to pay off their loans, so lenders are looking for borrowers who can pay off their loans quickly so they can get their money back as soon as possible.
The DSCR has become an important financial tool for lenders because it allows them to determine whether borrowers will be able to repay loans in full and on time.
Although there are other factors that lenders consider when determining whether they should approve loans, this ratio has become an important part of their decision-making process because it allows them to see how much money borrowers can borrow each month based on how much they already owe and how much they earn each month.
Understanding how the debt-service coverage ratio works and what it is used for can help you make smart decisions when borrowing money.