Are you looking for a new investment? Do you know what constitutes a worthy investment?
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As we dream of having the perfect homes, we should also be mindful of how the market works and how we can best find investment opportunities that align with our financial goals and situation.
In this crash course, we will be tackling one of the three calculations used to measure the dept capacity of a company or real estate. It is crucial that before any investment, we check how we can benefit from it both in the short and long term.
Understanding Debt Service Coverage Ratio
What is debt service coverage ratio? You may ask.
Debt service coverage ratio or DSCR is a metric that evaluates a firm’s ability to repay debts by checking its current cash flow and debt obligations.
Using its cash flow, DSCR guarantees investors, banks, analysts, and other financial institutions that this particular firm can pay its short and long-term debts on time. The ratio is usually used when firms have loans, bonds, and lines of credit on their financial sheets.
Further, debt service coverage ratio is used when eyeing investment through a leveraged buyout transaction. It is similar to other valuable metrics, such as net debt/EBITDA multiple, total debt/EBITDA multiple, fixed charge coverage ratio, and interest coverage ratio.
Significance of a DSCR
A DSCR helps banks in their risk management. For example, a creditor may require a guarantee that the DSCR to be above 1.25 after knowing that there is a high default risk.
Further, analysts and investors benefit from the use of DSCRs in conducting analysis of a company’s financial health in the recent and upcoming years.
Calculating Debt Service Coverage Ratio Manually
Knowing what is debt service coverage ratio is not enough, as calculations need to be followed to check your eligibility. In calculating the debt service coverage ratio, there are two ways:
DSCR = EBITDA / (Interest + Principal)
DSCR = EBITDA – CAPEX / (Interest + Principal)
EBITDA = Earnings Before Interest, Tax, Depreciation, and Amortization
Capex = Capital Expenditure
Principal = total loan amount of short-term and long-term borrowings
Interest = the interest payable on any borrowings
The EBITDA is also considered as net operating income or the firm’s revenue minus certain operating expenses (COE). It is crucial to note here that interest payments and taxes are not included.
Some firms might prefer using the second one in the two formulas above. Why? Because removing CAPEX from EBITDA gives firms the actual amount of current operating income to repay debts.
Another written is that CAPEX is not written as expenses but as investments on income statements.
As an investor or lender, one set of criteria must be constantly used when computing the debt service coverage ratio. At the same time, as borrowers, it should be noted that lenders or investors may calculate the debt service coverage ratio differently.
Calculating Debt Service Coverage Ratio Using Excel
In these modern times, the use of technology eases up the burden of manually calculating accounting metrics.
To compute the debt service coverage ratio using Excel, two successive cells will be needed, which will be labeled as “net operating income” and “debt service,” or four consecutive cells labeled as “EBITDA,” “CAPEX,” “Interest,” and “Principal.” Under them, respective figures from the income statement should be placed.
In a different cell, enter the formula by starting with an equal sign “=,” then click on former cells instead of manually inputting actual numerical values (e.g. =(B2-B3)/(B4+B5)).
Debt Service Coverage Ratio for a “No Income” Mortgage Loan
Applying for home loans is usually lengthy and tedious, with high rates and points of private loans, strict lending criteria, and extensive approval processes. With the debt service coverage loan, you can qualify not based on your income but your property’s cash flow!
Strictly speaking, the DSCR mortgage is a non-qualified mortgage loan that investors can use to expand their investment portfolio. Using DSCR, lenders evaluate the investor’s ability to repay debts without using income as the reference point.
Debt Service Coverage Ratio Loan Interest Rates
Understanding the DSCR loan interest rates helps borrowers and investors manage their portfolios and choose the best investment plan.
Two factors determine your interest rate for loans – debt service coverage ratio and borrower’s credit score, which will be discussed in the next section. Being in an urban or suburban area does not affect the interest rates.
As of June 14, 2022, a 6-Month SOFR ARM cash out refinance mortgage starts at an interest rate of 2.990% with 3.500% points and an APR of 3.768%.
The 40-year fixed cash-out refinance (interest only) starts at an interest rate of 6.125%, with points at 1.875% and an APR of 6.277%. The interest rate for a 40-year fixed purchase (interest only) is similar, but points increased to 2.625% and an APR of 6.339%.
The 30-year fixed cash-out refinance has the highest with an interest rate of 5.375% with 4.875% and an APR of 5.830%. Its counterpart in the fixed purchase has the same interest rate but lower points at 5.375% and an APR of 5.879%.
Debt Service Coverage Ratio Qualifications
When applying for a DSCR loan it is crucial to know DSCR loan qualifications guidelines. This way, you will see if you are qualified or not.
Being unqualified does not mean you have zero chance at loaning; it will make you see which aspect you should focus on improving to be eligible for the next time.
Borrower Debt-to-Income Ratio
Check your debt service coverage ratio to determine if you qualify for a loan since lenders routinely assess the DSCR of borrowers or investors before approving a loan.
Having a DSCR of less than one (1) means that the borrower will not be able to pay current debt obligations without borrowing more from other people and institutions.
For example, having a DSCR of 0.85% means that you can only cover 85% of your debt payments using your net operating income, which is unfavorable to your lender. Some may allow it but only if you have other substantial resources.
If your DSCR is too close to one (1), it shows vulnerability, and minor problems may jeopardize your debt repayment ability.
It is why most lenders require a certain minimum DSCR before the loan and while the loan is outstanding. Falling below the agreed minimum will be considered a default.
On the brighter side, having a DSCR of more than one (1) shows that the entity has enough income to pay its debt obligations – making you more likely to approve your application. The best minimum DSCR is 1.25.
Minimum Credit Store
A DSCR mortgage requires a minimum credit score of at least 640, but note that some lenders may have higher or lower minimums depending on their preference and other factors. This 640 credit score is similar to a standard investment property loan.
Summing It All Up!
If you are looking for an investment to buy, make sure to understand what is debt service coverage ratio and its importance.
A DSCR loan is helpful for investors who want to qualify for a mortgage based on cash flow and not on personal income. This way, you won’t have to provide your tax returns, pay stubs, and other vital documents in applying for a standard mortgage.
For more information, visit The Mortgage Shop. Professionals are here to help you.