As interest rates begin to decline from their recent highs, many real estate investors with Debt Service Coverage Ratio (DSCR) loans are considering their options to optimize their current loan terms. DSCR loans have become a popular tool for real estate investors, as they focus on the cash flow of the investment property rather than the borrower’s personal income. With lower interest rates now on the horizon, refinancing your DSCR loan could help improve cash flow, reduce debt service costs, and possibly allow you to leverage new investments.
In this article, we’ll explore refinancing options, including longer fixed terms, different prepayment options, interest-only periods, and the strategy of LTV Stacking to finance points. Additionally, we’ll dive into how to calculate the cost of refinancing if you have a prepayment penalty and how to conduct a breakeven analysis to determine whether refinancing is a smart financial move for your real estate portfolio.
Understanding DSCR Loans
Before diving into refinancing options, it’s essential to understand the nature of DSCR loans. Unlike traditional loans that focus on a borrower’s personal income or employment, DSCR loans use the income generated from the investment property to determine the borrower’s ability to repay. The DSCR is calculated by dividing the property’s net operating income (NOI) by its debt service obligations. A DSCR of 1 or greater typically indicates that the property generates enough income to cover its loan payments.
This makes DSCR loans particularly attractive for investors who own rental properties, multi-family units, or commercial real estate. They offer flexibility but often come with higher interest rates compared to conventional mortgages. However, with interest rates beginning to fall, now is the perfect time for investors to review their DSCR loans and consider refinancing.
Why Consider Refinancing Now?
According to Freddie Mac, 30-year mortgage rates peaked in late 2023 at over 7%, the highest level seen since the early 2000s. While this pushed borrowing costs higher, the Federal Reserve has signaled that it might reduce rates in response to cooling inflation and economic conditions. As of early 2024, mortgage rates have begun to fall, with projections suggesting continued moderation throughout the year.
Lower interest rates offer real estate investors an opportunity to reduce their debt service costs, free up capital, and potentially expand their portfolios. For those holding DSCR loans, refinancing now could lock in a lower rate for the long term, which will be especially beneficial for properties that are already cash-flow positive. Here’s a look at several refinancing options and strategies to consider.
1. Opt for a Longer Fixed Term: 40-Year or 30-Year Fixed-Rate Loans
One of the first decisions you’ll face when refinancing is the loan term. Most borrowers are familiar with the standard 30-year fixed-rate mortgage, but many lenders now offer 40-year fixed-rate options. Both options have their pros and cons:
- 40-Year Fixed-Rate Loan: A longer loan term means lower monthly payments, which can improve your property’s cash flow. However, the downside is that you will pay more interest over the life of the loan. This option can be appealing if your goal is to maximize monthly cash flow, especially if you plan to hold onto the property for a long time. According to data from the Mortgage Bankers Association, 40-year fixed loans are becoming more common in real estate investments as they provide investors with additional payment flexibility.
- 30-Year Fixed-Rate Loan: A 30-year term will result in higher monthly payments compared to a 40-year loan, but you’ll pay off the loan faster and save on interest over time. This is a great option for those looking to balance cash flow and long-term savings. With rates starting to decline, locking in a 30-year rate now can also protect you from future rate hikes.
When deciding between a 30-year and 40-year fixed loan, consider your investment timeline. If you plan to hold the property for a shorter period, lowering your monthly payments in the near term could make more sense.
2. Explore Different Prepayment Options
Refinancing also gives you the chance to reconsider your prepayment options. Many DSCR loans come with prepayment penalties, which are fees charged if you pay off the loan early or refinance before a certain time. However, lenders typically offer multiple prepayment structures, including:
- Declining Prepayment Penalties: These penalties decrease over time, usually starting high in the first few years and gradually decreasing. For instance, you may face a 5% penalty in year one, 4% in year two, and so on until the penalty expires.
- No Prepayment Penalty Options: Some lenders offer loans with no prepayment penalties, but these come with slightly higher interest rates. If you plan to sell or refinance the property within a few years, this could be a good option.
- Customizable Prepay Structures: Depending on your lender, you might be able to negotiate a prepayment penalty structure that fits your long-term goals. For example, if you plan to hold the property for five years, you might accept a higher penalty in the early years in exchange for lower penalties later.
Prepayment penalties can significantly impact your financial flexibility, so it’s important to align your prepayment terms with your investment horizon.
3. Consider Interest-Only Periods to Maximize Cash Flow
Another popular feature for DSCR loans is the interest-only payment period. With interest-only loans, you only pay the interest on the loan for a set period, typically 5 to 10 years, after which you begin paying both principal and interest.
- Pros of Interest-Only Loans: The primary advantage of interest-only loans is lower monthly payments during the interest-only period. This can dramatically improve your property’s cash flow, especially if you’re in a high-growth market or plan to reinvest the cash into new properties.
- Cons of Interest-Only Loans: The downside is that your loan balance does not decrease during the interest-only period, so you’re not building equity. Additionally, once the interest-only period ends, your payments will increase as you begin to pay both principal and interest.
If your goal is short-term cash flow optimization, interest-only loans can be an excellent choice, but make sure you have a strategy for managing higher payments once the interest-only period ends.
4. Leverage LTV Stacking to Finance Points
One lesser-known strategy that can significantly reduce your interest rate is LTV (Loan-to-Value) stacking. In simple terms, LTV measures the ratio of the loan amount to the appraised value of the property. By stacking LTVs, you can leverage your property’s value to finance loan points, effectively reducing your interest rate. Here’s how it works:
- Financing Points: Points are fees paid to the lender in exchange for a lower interest rate. One point typically costs 1% of the loan amount and can reduce the interest rate by about 0.25%. In some cases, refinancing at a lower LTV can allow you to roll the cost of points into the loan, reducing your out-of-pocket expenses.
- Example of LTV Stacking: Suppose you’re refinancing a $500,000 DSCR loan at an 75% LTV. Your lender might offer LTV Stacking, which would allow you to finance buydown points without increasing your loan’s leverage bracket which would then increase your rate. Structuring a loan at 75% LTV, and then financing 2 or 3 points to reduce your rate and/or offset prepayment penalties without winding up in the 80% LTV pricing tier can be extremely beneficial for maximizing cash flow efficiency.
When considering LTV stacking, it’s important to carefully assess your property’s value and your long-term financial goals. While financing points can help reduce interest rates, it can also increase your loan balance, so make sure the strategy aligns with your overall investment plan.
How to Calculate the Cost of Refinancing When You Have a Prepayment Penalty
Refinancing your DSCR loan can be a smart financial move, but it’s crucial to understand the full cost of refinancing, including any prepayment penalties that might apply. Prepayment penalties are common in DSCR loans and can significantly impact the overall cost of refinancing. Here’s how to calculate the cost of refinancing and perform a breakeven analysis to determine when the savings from the new loan will outweigh the costs of refinancing.
Step 1: Determine the Prepayment Penalty on Your Current Loan
Prepayment penalties can vary depending on the terms of your DSCR loan. To calculate your total prepayment penalty, review your loan documents. The penalty might be a flat percentage of the remaining loan balance or follow a declining structure where the penalty decreases over time. For example:
- Flat Percentage: If your penalty is 3% on a $500,000 loan balance, your penalty is $15,000.
- Declining Penalty: A 4% penalty on a $400,000 balance in year two would be $16,000.
Step 2: Estimate Closing Costs for the Refinance
In addition to the prepayment penalty, refinancing comes with closing costs, typically 2% to 6% of the loan amount. These include lender fees, appraisal costs, and title insurance. For example, refinancing a $500,000 loan with 3% closing costs would amount to $15,000.
Step 3: Calculate Total Refinancing Costs
Add the prepayment penalty and closing costs to determine the total cost of refinancing:
Total Refinancing Cost = Prepayment Penalty + Closing Costs
For instance, if your prepayment penalty is $10,000 and closing costs are $15,000, your total cost of refinancing is $25,000.
Step 4: Conduct a Breakeven Analysis
A breakeven analysis will help you determine how long it will take for the savings from the new loan to cover the upfront refinancing costs. Here’s how to calculate your breakeven point:
- Calculate Monthly Savings: Find the difference between your current and new monthly payments. For example, if refinancing lowers your payment from $2,398 to $2,147, your monthly savings would be $251.
- Calculate the Breakeven Point: Divide the total cost of refinancing by your monthly savings to find the breakeven point:
Using our example, if the total cost of refinancing is $25,000 and your monthly savings are $251, your breakeven point would be about 99.6 months, or approximately 8.3 years. After this period, the savings from your new loan will exceed the upfront costs of refinancing.
Conclusion: Maximizing Your DSCR Loan in a Falling Rate Environment
As mortgage rates start to come down, real estate investors have a unique opportunity to optimize their DSCR loans through refinancing. Whether you’re looking to lower your monthly payments with a 40-year fixed-rate loan, improve your financial flexibility with a better prepayment structure, or increase cash flow with an interest-only option, now is the time to evaluate your options.
Additionally, LTV stacking offers a sophisticated approach to lowering your interest rate by leveraging the property’s value to finance points. This strategy can save investors significant amounts of money in interest payments over the long term. However, it’s essential to carefully calculate the cost of refinancing, especially if your current DSCR loan has a prepayment penalty. By conducting a breakeven analysis, you can ensure that the long-term savings from refinancing outweigh the immediate costs.
The key to a successful refinance is aligning your loan structure with your investment goals, cash flow needs, and market conditions. In a market where interest rates are falling, taking advantage of refinancing opportunities could be the key to unlocking more cash flow, reducing debt service, and setting yourself up for future investment success.