Debt Service Coverage Ratio (DSCR) loans are a popular borrowing option in the UK, especially for real estate investors. DSCR loans allow you to qualify for financing based on the income potential of the property rather than your personal income and credit score.
However, first-time DSCR borrowers often make mistakes that can lead to inaccurate assessments of their ability to repay the loan or getting a loan that isn’t well-suited to their situation. Avoid these common first-timer mistakes when seeking DSCR financing in the UK.
Getting Inaccurate or Misleading DSCR Results
The Debt Service Coverage Ratio compares your property’s net operating income to your proposed debt payments. Lenders want to see that your NOI is high enough above your debt service to demonstrate your property can support the loan repayment terms.
Basing DSCR on Unreliable NOI Projections
A common mistake is using projected income and expenses to calculate DSCR rather than proven historical performance. Projections are guesses, and beginning investors often optimistically overestimate potential rental income.
Not Accounting for Vacancies and Maintenance
Aim for vacancy rates of 5-10% of potential rental income depending on the market. Budget at least 10% of rent for maintenance and repairs. And factor in 8-12% for property management if you won’t self-manage.
Misrepresenting Rehab Costs and Timelines
If undertaking renovations, take care to accurately represent the costs, scope, and timeline of the project. It’s easy to underestimate rehab costs, timelines, and potential rental rate increases.
Work with experienced contractors to develop your budget and timeline. Get comparable rents post-renovation from agent or appraiser.
Not Understanding DSCR Loans
DSCR loans have unique qualifying guidelines and terms you need to understand before borrowing. Mistakes stem from not fully grasping DSCR lending.
Confusing DSCR Loans and Conventional Mortgages
Conventional mortgages qualify you based on your income, credit, and down payment amount. DSCR loans focus on the property’s financials, not yours.
DSCR loans typically require 25-35% down and have higher rates and shorter terms than conventional loans. Loan qualifications are based on property, not borrower.
Not Realizing DSCR Loans Are Riskier for Lenders
Because DSCR lenders take on more risk, they scrutinize deals more carefully and have stricter requirements. Higher vacancies or lower rents can put you in default faster than a conventional loan.
Be conservative in your projections and pro formas and know the property market well. Have contingency plans for higher vacancies or lower rents.
Expecting to Refinance Easily into Conventional Loans
Many first-timers expect to refinance out of a DSCR loan into a lower-rate conventional mortgage once they establish a history of on-time payments.
But refinancing is not guaranteed. You still need to qualify based on your income and credit. Be prepared and willing to hold the DSCR terms long-term.
Not Getting an Investor-Specific DSCR Loan
Using a Residential Loan for a Rental Property
Don’t make the mistake of using a residential DSCR loan for an investment property. Residential loans have stricter occupancy requirements that usually prohibit renting out the property.
Not Shopping Around with Different Lenders
Each lender has its own DSCR loan programs and requirements. One lender may want 30% down while another may accept just 25% for your particular deal.
Shop your deal around with multiple commercial lenders to find the best loan program and terms for your specific property situation. Pre-qualification is simple and doesn’t affect your credit.
Miscalculating the DSCR
Properly calculating your property’s Debt Service Coverage Ratio is critical for qualifying and securing favorable loan terms. Avoid these DSCR calculation mistakes.
Using Gross Rental Income in the DSCR
A major mistake is plugging gross rental income into the DSCR formula rather than net operating income. Lenders look at NOI, not gross receipts.
Correctly calculate NOI by subtracting all expenses from gross rents. Vacancy, maintenance, management fees, taxes, insurance, etc. must be deducted.
Not Factoring in the Entire Proposed Loan Payment
Another common error is entering just the proposed loan’s principal and interest payments into the DSCR formula, leaving out property taxes and insurance.
The full monthly loan payment includes principal, interest, property taxes, insurance, and any HOA fees. The DSCR must factor in all these payments.
Mixing Up DSCR and LTV Formulas
Some first-timers mistakenly use the Loan-to-Value (LTV) formula instead of the correct DSCR formula to calculate their ratio. This results in an incorrect, inflated number.
Be sure to divide the net operating income by the total proposed debt service, not the loan amount divided by property value to get your true DSCR.
Not Shopping Around for the Best DSCR Loan
The terms and requirements for DSCR loans can vary significantly from lender to lender. Failing to compare loan offers could cost you thousands.
Not Checking Broker vs. Direct Lender Offers
Mortgage brokers have access to wholesale lender programs that typical retail banks don’t offer. But some brokers are limited to certain investors.
Not Comparing Enough Lenders
Don’t stop at just one or two lender quotes. The more lenders you apply and compare offers with, the better deal you’re likely to secure.
Aim to get 4-5 loan quotes from different commercial banks, credit unions, mortgage brokers, and private lenders to find the optimal loan program.
Focusing Only on Interest Rates
Scrutinize and compare all the factors of the loans offered – not just the interest rate. Doing so can save you thousands over the loan’s lifespan.
Key Takeaways on Avoiding First-Timer DSCR Mistakes
If you keep these keys tips in mind, you can avoid the most common pitfalls and secure the best first-time DSCR real estate loan in the UK:
- Base projections on proven property performance data, not guesses
- Account for vacancies, repairs, management costs in your NOI
- Accurately estimate renovation costs, timelines, and rent bumps
- Understand DSCR loan differences from conventional mortgages
- Get a commercial loan designed for rental properties
- Shop multiple lenders to compare loan programs and terms
- Use net operating income, not gross rents in DSCR
- Factor total proposed payment including taxes and insurance
- Compare all loan costs, terms, and requirements thoroughly
DSCR loans can be great financing tools for real estate investors, allowing you to qualify based on the property rather than your personal profile. Avoid these first-timer mistakes and you can confidently leverage DSCR lending to build your property portfolio.