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A straightforward but meaningful aspect of DSCR Loans is the loan purpose, or the reason a borrower is getting a DSCR Loan. Typically this is split into two categories: Acquisitions or using a loan, along with a “down payment” of cash, to purchase the property. The other category is Refinances, where the borrower already owns the property being mortgaged through the DSCR Loan, and is taking out a new loan to replace (by paying off the prior loan) the previous one or if the property is owned with no debt (called “free and clear” or “unencumbered” in real estate lingo), to take out a loan on the previously debt-free property.
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DSCR Loans that are refinances are further split into two different categories as well, and are typically referred to as “Cash-Out Refinances” or “Rate-Term Refinances.” The key differences between these two types of refinance types is how much cash the borrower gets at closing. Generally, if the amount of the new loan is more than $2,000 greater than the balance of the prior loan plus closing costs and escrows, it is a cash-out refinance. So if the borrower walks away with greater than $2,000 at closing (the typical threshold to delineate cash-out vs. rate-term refinances, also can sometimes be the greater of 2% of new loan amount or $2,000), it is a cash-out refinance. This would also include essentially all refinance transactions on properties previously owned free and clear., as the “balance of the prior loan” in this case would be $0.
All other refinances, where the new loan minus any prior loan balance and closing costs and escrows is either less than $2,000 or negative, would be considered rate-term refinances, as the investor would only walk away with at most, minimal cash proceeds from the transaction. In cases where the formula results in a negative number (i.e. the new loan amount is less than the balance of the prior loan being paid off plus escrows and closing costs), then the borrower must cover the difference at closing out of their personal assets. This is typically referred to in industry lingo as “bringing cash to the table” on a refinance transaction. While these types of refinances fall under the rate-term refinance bucket, some people have begun referring to these types of refinances (typically snarkily) as “cash-in refinances,” but for purposes of DSCR Loans when it comes to qualification, pricing and everything else, are treated and labeled the same as other rate-term refinances where very slight proceeds (under $2,000) are received.
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Why do real estate investors use DSCR Loans in these contexts? One of the great features of DSCR financing is the multiple reasons why they can be the choice for investors. Using DSCR Loans for acquisitions (i.e. to purchase a rental property) is pretty straightforward, it allows investors to use leverage to accelerate the growth of their portfolios and enhance returns via appreciation (as discussed in the section above).
Refinances can be done for many reasons and in many scenarios. One main motivator for refinances is if interest rates are more favorable, whether because market rates have fallen or a borrower’s credit profile has improved (or both) since origination and getting a new loan will be an improvement on the old one just in terms of a lower rate and monthly payment. DSCR Loans are a top option for the BRRRR Strategy which often includes using a hard money loan with a very short term (like 6-9 months) that needs to be refinanced quickly due to its rapid maturity. In addition, Cash-Out Refinances are extremely popular among real estate investors building wealth as it allows investors to turn equity “trapped” in the property into cash, often allowing that cash to be deployed to earn higher returns, especially through buying more properties. Additionally, since cash-out refinances are loans, the cash-out proceeds are not a taxable event, since it’s not income, it’s a new loan. This means that investors can access gains in real estate without selling the property, continuing to earn outsized returns and grow their portfolios without having to pay taxes on the returns (or at least defer taxes to the future).
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