The Debt Service Coverage Ratio (DSCR) is a key metric lenders use to assess a business’s ability to meet its debt obligations. The DSCR measures the cash flow available to pay current debt payments.
Specifically, the DSCR is calculated by dividing net operating income by total debt obligations over a period of time. A higher DSCR indicates a greater cushion for making debt payments.
For lenders, an adequate DSCR provides assurance that the borrower can adequately service new debt. Typically, lenders prefer a minimum DSCR of 1.20 or higher. A DSCR below 1 suggests that a business may not generate sufficient cash flow to cover debt payments.
How Do Lenders Use the DSCR in Underwriting Loans?
Lenders analyze the DSCR to determine if a business qualifies for a loan and at what terms. A weak DSCR may cause lenders to:
- Deny loan applications
- Require a higher interest rate
- Reduce loan amount offered
- Demand more collateral
Conversely, a strong DSCR makes it easier to obtain financing with better terms.
Why Should Borrowers Care About Improving Their DSCR?
For borrowers seeking financing, enhancing your DSCR can provide several benefits:
- Increase likelihood of loan approval
- Qualify for larger loan amounts
- Obtain lower interest rates, saving substantially on financing costs
- Reduce need for collateral
- Access better loan terms and conditions
How Can You Improve Your Business’ DSCR?
If your DSCR is below the typical 1.20 threshold, here are some strategies to consider boosting your ratio:
1. Increase Net Operating Income
- Drive higher sales and revenues
- Review pricing and optimize to increase profit margins
- Reduce operating expenses without impacting revenues
Even marginal gains in NOI can deliver outsized improvements in your DSCR.
2. Extend Loan Amortization Period
Amortization refers to the loan repayment schedule. The amortization term impacts your periodic principal and interest payments.
Opting for a longer amortization period – say 25 years instead of 10 years – reduces your periodic debt payments. In turn, this decreases the debt obligation component of the DSCR formula.
Just be aware that a longer amortization increases total interest paid over the life of the loan.
3. Obtain an Interest-Only Loan
With an interest-only loan, you pay only interest (no principal) for the term of the loan. The principal must be repaid in a lump sum at maturity.
This arrangement minimizes your periodic debt payments during the loan term, thereby increasing your DSCR. Interest-only loans may be an option for situations like construction loans.
However, you still need to underwrite ability to repay the full principal at maturity. Failing to do so can cause the loan to default.
4. Pay Down Existing Debt
Reducing existing debt obligations directly improves your DSCR by decreasing total debt service commitments.
Target paying down high interest rate debt first. Be strategic by timing new financing needs when you’ve freed up cash flow by retiring older debt.
5. Refinance Existing Debt
Similar to paying down existing debt, refinancing can reduce your total debt obligations in the DSCR equation.
Refinancing involves getting a new loan to pay off an existing loan. Look for opportunities to refinance at a lower interest rate or longer amortization period to reduce periodic payments.
6. Improve Operating Efficiencies
Carefully examine your operating processes to identify areas for improved efficiency. For example:
- Implement automation to reduce labor costs
- Renegotiate contracts with suppliers for better pricing
- Eliminate underperforming product lines or services
- Reduce inventory waste and carrying costs
The resulting expense savings can directly improve your NOI and DSCR.
7. Delay Capital Expenditures
While capital investments are often vital for growth, their timing can negatively impact your DSCR.
Look for opportunities to defer major capital expenditures until after you’ve obtained new financing. This avoids diverting cash flow away from debt service.
How Can You Improve Your Personal DSCR When Seeking a Mortgage?
The concepts for improving a business DSCR also apply for individual borrowers seeking a mortgage. A few key personal finance tips include:
- Pay down existing high interest rate debts
- Refinance existing mortgage(s) at lower interest rate
- Reduce your overall personal debt obligations
- Build savings to make a larger down payment, reducing loan amount
- Opt for longer mortgage amortization period
- Understand how your income sources impact DTI ratio used in underwriting
Maintaining a strong personal financial profile makes it easier to qualify for a mortgage and favorable loan terms.
What DSCR Thresholds Do Lenders Look For?
While specific requirements vary by lender and loan type, the typical DSCR thresholds sought are:
- Minimum 1.20 DSCR: This is the baseline that provides adequate assurance of repayment capability. Below 1.20 raises concerns about risky cash flow.
- 1.25 to 1.30 DSCR: This range allows some cushion for cash flow fluctuations. Many lenders prefer to see at least a 1.25 DSCR.
- 1.50+ DSCR: A DSCR above 1.50 indicates very strong cash flow and debt service capacity. Creditworthy borrowers can qualify for the most favorable loan terms at this level.
- 2.00+ DSCR: Reaching this high standard effectively removes concerns about repayment risk. Borrowers may qualify for specialty loan products at a 2.00+ DSCR level.
Aim for the highest DSCR possible when approaching lenders. A strong ratio ensures you are viewed as a low risk, appealing customer.
Key Takeaways on Improving Your DSCR
- The Debt Service Coverage Ratio indicates ability to meet debt obligations. A higher DSCR improves financing options.
- Increase net operating income, extend loan terms, refinance existing debt, and lower other obligations to enhance your DSCR.
- Work to achieve a minimum DSCR of 1.20, but ideally reach 1.25 or higher. The higher your ratio, the better the loan terms you can qualify for.
- For individuals, build savings, pay down debts, and improve your overall personal financial profile before applying for a mortgage.
Proactively managing your DSCR puts you in a stronger position to qualify for the essential financing needed to start or grow your business.