DSCR Loan vs Conventional: Which Really Costs Less?

DSCR loan vs conventional loan: which one actually costs less for your rental property? The interest rate on a DSCR loan usually looks higher on paper, but once you factor in conventional pricing adjusters and the prepayment penalty lever, the math often flips. Ryan Marks explains how investors can structure a DSCR loan for the long term and stop obsessing over the wrong number.

In this episode:

• Why conventional investment property loans aren't as cheap as they look
• How DSCR loans qualify on rental cash flow instead of tax returns
• Down payment differences, loan limits, and financing up to 12 units
• Step prepays vs flat prepays and how they lower your rate
• The refinance breakeven math most investors never run

See what you qualify for at seimortgage.com

Ryan Marks | NMLS #519138 | SEI Mortgage | Equal Housing Lender. Educational content only, not a commitment to lend.

Transcript

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If you're shopping a DSCR loan next to a conventional loan, you've probably noticed the interest rate's higher and your guts telling you to run. Hold on because understanding how the fees actually work and the lever that most people don't talk about will be the difference between you going with a DSCR loan versus a conventional loan. On today's episode, we're going to cover the difference between conventional versus DSCR fees, how to structure a prepay for a rate buy down, and the most important question, which is not what's my interest rate? Let's get into it. So let's clear something up because this is where most investors get it wrong. On a conventional loan, you're qualifying on you, your personal income, your tax returns, your W-2s, your pay stubs, your debt-to-income ratios. And most people forget that conventional investment property loans are hit with pricing adjusters. Your occupancy, your credit score, and your loan to value, all of these things are stacked up and baked into your interest rate. So conventional doesn't always mean cheaper when it comes to an investment property. A DSCR loan, however, is a business purpose loan and it's using the property's cash flow in order to qualify versus your debt to income, which is stacked up on everything about you. No W-2s, no pay stubs, no tax returns. You're qualifying simply based on how much rent you receive versus how much your total properties payment, including taxes, insurance, and any applicable homeowners association dues. You still have to take into consideration your credit score, which is one of the driving factors of your interest rate, and the fact that these loans are typically sold on the secondary market. That's where you're seeing the additions to the interest rate that you're receiving on your final proposed rate based on the mortgage term that you selected. So on paper, yeah, the DSCR may have higher costs up front or a higher interest rate, but the huge trade-off is the ability to qualify for this loan product. And there is currently no limit on the amount of DSCR loans that you can have, whereas conventional, you are still capped. And when it comes to the down payment, the DSCR loan does have the ability to go as low as a 15% down payment. Spoiler alert, you typically have to have a 1.2% debt coverage or greater. However, there is no mortgage insurance if you can qualify at the 15% down. Typically, it is a 20% down payment. Whereas conventional loans, you need a minimum of a 20% down payment on a single unit property and a minimum of a 25% down payment on multi-units in the two to four space. And on top of that, we have financing available for up to 12 unit properties, where that is typically reserved for the commercial space and no conventional financing would be available after four units, even if you were putting the minimum 25% down payment. So, how do we get past the extra cost? Well, here's the lever. If you utilize it correctly and it makes sense for your particular property, you can take advantage of a prepayment penalty on this particular loan. So here's how it worked because this is a business purpose loan and not conventional, you have the ability in most states to utilize a prepayment penalty from one year all the way up to five years, which will further pull the lever down on your all-in interest rate. These common prepays can be step prepays, meaning they reduce the amount of fee associated based on the first year all the way into the fifth year, or you could utilize a standard flat percentage from one to five years, meaning whether you pay that loan off early the first year, or you go all the way just before the fifth year, the prepayment penalty amount would remain the same. Why that's so important is because if you're thinking long-term for this property, your intention is to make this into a rental property where you're receiving positive cash flow and you have no intention of selling the property early, you can take advantage of up to a five-year prepayment penalty, which would drastically drive down the interest rate, oftentimes matching or even beating what the current conventional interest rates are, even utilizing the lower 20% down payment. So let's break that down further. Let's say you are purchasing a property where there's not much positive cash flow, but you are debt coveraging, meaning that the amount of rents that you're receiving are just barely covering the mortgage payment to include all the estimated taxes and insurance. And maybe you're going to do work on the property over time to further increase rents to stabilize it, where you're getting full fair market value. And in the meantime, you've already secured a much lower interest rate because you know you're going to hang on to that property for the long term, or at the very least, the amount of time until the prepayment penalty expires. So some of you may be thinking, well, what if interest rates drop, right? Depending on when you're watching this, we've been in an inflated rate environment for quite some time, and we are overdue for an interest rate reduction where a lot of us can take advantage of refinancing for a lower interest rate, even on rental properties. Here's the thing that you have to understand depending on where you own this property, unless you have a larger loan amount, typically 500,000 minimum and above, you're still responsible for closing costs, even when you're taking advantage of a rate reduction. So let's say your standard closing costs are around $4,000 to include title, escrow, notary, processing, underwriting, all the one-time third-party fees that you incur whenever you redo the mortgage. So even if you're staying in the property or it's currently a rental property and you're just changing the interest rate, you have to go through the process. So let's put the prepayment penalty into a real example. Let's say you have a mortgage on your current investment property or a property that you're purchasing. And right now the current interest rate is at 7.25% with no prepayment penalty. That would give you a principal interest payment of $2,046 a month on a 30-year mortgage. And let's say you utilized a five-year prepayment penalty, which drove the interest rate down to six percent, which is one and a quarter less than what the no prepayment penalty option would be, giving you a payment of $17.98 principal and interest. That is a $247 difference in payment. So stay with me. Now let's say you went with the 30-year option at the 7.25% with no prepayment penalty, and interest rates drop next year to six percent, meaning that the market would have to come down one and a quarter percent on an investment property, not a standard conventional 30-year fixed owner-occupied residence. So typically, interest rates on a rental versus a primary residence on average are a half to three quarter percent higher in interest rate on that particular type of loan product due to the occupancy. But in this hypothetical, if the interest rates were to drop that low in one year from seven and a quarter to six percent, that would give you a monthly payment savings of $247 a month, but it costs you four thousand dollars in closing costs in order to go through the refinance process. So that would take you 16 months to recoup that cost. If it was four thousand dollars divided by 247, gives you 16 months, meaning you don't want to refinance that loan within that first 16 months of closing, or you would have left money on the table for the closing costs it took to take advantage of the lower rate when interest rates dropped. But if you took advantage of a prepayment penalty up front, giving you that lower rate over the long run, you don't have to worry about refinancing when interest rates drop and more importantly, paying those costs associated again in order to take advantage of the lower rate. So you can see if you're looking at the property from a long-term perspective, it may be advantageous to utilize a prepayment penalty, even if it's only for one year, just due to the fact that you're avoiding having to pay the closing costs again, versus taking advantage of the lower payment up front, giving you more positive cash flow out of the gates. That is the most important thing that you have to understand. This is not your primary residence. The intended purpose is is this property positive cash flowing before I put it into my portfolio, or how soon can I get it to positive cash flow so it's a good asset for my real estate portfolio. So if you're considering purchasing a property and utilizing the DSCR loan, I'd welcome the opportunity to have a conversation about you if a prepayment penalty, if utilizing the prepay lever is a good idea for your strategy and how we can best structure your real estate portfolio. For other great tools and resources, head over to SCIMortgage.com where you can also get in touch with us. And until then, remember to let your income work smarter, not harder. We'll see you on the next one.