What on earth is a debt service coverage ratio “DSCR”? Well, a DSCR is a measure of your cash flow available to pay your debt obligations. Based on this term, the ratio is utilized as a measure when debt payments are involved. Usually, a lender will look at the DSCR when you are attempting to take out a loan for a car or mortgage for a home. Additionally, DSCR loans are commonly used in the realm of real estate investment.
Lenders expect to be paid back, and it is risky for them to lend to a borrower that does not have a high level of expected cash flow, or at least enough to cover the debt that is owed to them. For instance, it may be difficult for you to borrow from a lender if you don’t have a job contract signed for the next year. In this light, lenders cannot assume you will be able to pay your principal and interest payments back in a timely manner.
The standard calculation is done on an annual basis. (Annual net income) divided by (Annual debt service, in the form of principal and interest payments) So if you have income of $50,000 per year and debt service of $40,000 per year, then your DSCR ratio is 1.25x. In general, if your DSCR ratio is above 1, that is seen as positive from a lending standpoint, while less than one is negative.
Why This Matters To You
This matters to you because now you know that when you try to take out a mortgage or buy anything on credit (a loan), then you will need to show proof that you have the income to pay off that loan. This is done to protect the lender, but also to protect you. Think about it, if you were able to take out a loan without any background check, many people would go into SERIOUS DEBT, which can be very stressful, once it needs to be paid back.
In general, it is important to think closely before taking out a loan, even if a lender agrees that you can pay it back. For instance, if you have a DSCR ratio of 1.1, perhaps you can pay the loan, but also keep in mind that you will also need to pay rent, pay for food, utilities, clothes, commuting to work, etc. which all needs to be considered for.
Keep in mind that most lenders will also look at other factors, such as you credit score.
How to Improve Your DSCR
Well, this should be very straightforward! There are two factors involved, income, and debt service. So we either raise our income, or decrease the debt we need to service. Lets start with income, there are many ways to increase it, if, and it is an important if, you are willing to work hard. We have discussed previously on this site, the benefit of a long term career. A career will help keep your long term income stable (and likely increasing year over year), which will help you in the case you do in fact need a loan.
Decreasing your debt service may be more nuanced and difficult, but you may be able to play one lender off another, to lower the interest rate on your loan. For instance, if you are able to get a 4% loan from one lender, you can leverage that, and ask another lender if they can offer 3.5%. Keep in mind, their rates may be predetermined based on your credit factors, but it cannot hurt trying.
Build Wealth
A caveat and main takeaway of this article should be clear. As your long as you are finding ways to build wealth, you will not need to worry about DSCR long term, but it does come in handy to understand for any dealing with a lender. This includes entrepreneurs, as you may need to take out certain loans from time to time, and it helps to be educated when speaking to a banker. The point is to focus mostly on your skills and income, and the rest will fall in place.
Is Debt Okay?
A last point, we want to be clear that utilizing debt should be analyzed in detail beforehand. For instance, if you are considered taking out a mortgage for $200,000 you should ask yourself several questions. Do you plan to stay at that location in the long term? Are housing markets at a low point? If they are at a high point, and the value declines significantly, you will be in a horrible position if you needed to sell it. Does having that amount of debt make you feel very stressed? Then don’t borrow the money. Otherwise, you’re in good shape. In general, we recommend paying in cash if you have enough on hand, but there are situations where a small portion of debt can make sense.
As always health is number one. Thanks for reading.