What is debt service? Calculating the coverage ratio

Your three-digit FICO® credit score effectively provides a snapshot of your financial health to prospective lenders. It’s a key number to keep in mind when applying for a mortgage. If the score is too low, lenders will hesitate to approve you for a loan. Conversely, the higher your score, the more loan opportunities and better terms and conditions you’ll generally qualify for.

But did you know that your total debt service is another important financial factor that also helps determine whether you qualify for a mortgage? Let’s talk about what total debt service means in real estate and how to calculate it.

What is debt service?

If you’re looking for a definition, your debt service describes the total amount of money that you need to have on-hand to fully repay the scheduled principal and interest payments of a specific debt obligation over a certain predefined period of time. You can calculate your total debt service for a month, a year or any other preferred period.

What is debt service’s significance?

Given that any money lent to an individual inherently comes with risks attached, lenders are generally cautious when approving loans. In effect, before extending financing and cutting a check, they want to make sure that borrowers can afford making their debt payments consistently and on time.

Debt service calculations help lenders in their efforts to determine a potential borrower’s ability to meet payment obligations over the life of the loan. In effect, if borrowers’ debts already appear to consume too much of their gross monthly income (which raises potential red flags), lenders will be more hesitant to approve them for a loan.

An overview of debt service

The total amount of your debt service helps measure the percentage of your gross annual income that you would need to cover your regular loan payments and yearly debts. Gross annual income is a figure that refers to your yearly income before taxes are taken out.

It’s utilized in similar fashion to your debt-to-income ratio (DTI) in that it analyzes how much of your income is being consumed by your debt obligations each month, or on an annual basis.

In effect, taking on a higher amount of debt means that you’ll have to spend a greater percentage of your gross annual income on paying off the debt obligation. If you want to borrow money, it’s best to have a lower total debt service. Having fewer obligations to meet will make lenders feel more confident that you can afford to pay your new monthly loan payment because you’ll have more available cash on-hand.

What is the debt service coverage ratio (DSCR) in real estate?

The DSCR, or debt service coverage ratio, measures how much of your income any given debts consume. Mortgage lenders, for instance, utilize the figure to determine how much of your income would potentially go toward paying off your overall housing costs. Housing expenses include your estimated new mortgage payment, including principal, interest, property taxes, homeowners insurance, and HOA fees if you have them.

How DSCR works in real estate

Lenders will consider you to be more of a risky borrower if you’re spending too much of your income on housing costs. For example: If you’re spending 50% of your overall income on housing, you're far more at risk of missing payments in their eyes than if you’re spending just 20% of it on these costs.

Note that if a new mortgage payment appears to result in you potentially spending too much of your income on housing costs, lenders will be more likely to reject your mortgage application. Similarly, if lenders do approve you for a loan and too much of your income is being used on housing costs, they’ll usually charge you a higher interest rate to help offset and mitigate some of the risk that they appear to be taking on.

How to calculate your debt service coverage ratio

Your debt service coverage ratio is calculated by dividing your net operating income (NOI) by your total debt service. The DSCR formula looks like this in practice:

DSCR = Net Operating Income / Total Debt Service

For simplicity’s sake, note that the higher your DSCR, the healthier it is … and the more successful that you’ll likely be with your loan application.

• If your DSCR is lower than 1.0, it indicates that you don’t have enough income to cover your mortgage payments.
• If your DSCR is exactly 1.0, it would indicate that you make exactly enough to make your mortgage payments and nothing more.
• If your DSCR is higher than 1.0, it would indicate that you can cover your loan payments with cash left over to spare.

Individual lenders will have different minimum DSCR requirements. However, as a general rule, you can expect a lender to set a minimum DSCR of around 1.1 – 1.25.

As you can see in the equation above, you’ll need to know a few other numbers in order to calculate the figure – specifically, your net operating income and your total debt service.

Net operating income

Net operating income is frequently used in business and real estate investing. It helps calculate the total amount of income that a business or investor would make after expenses are taken out. For businesses, the equation would be:

NOI = (Gross Operating Income + Other Income) - Operating Expenses

For those who don’t own a business, this would just be your yearly gross income (what you make before taxes are taken out). You wouldn’t need to subtract any operating expenses. For home buyers without a business, NOI = annual gross income.

To get your yearly gross income, add up your salary, any freelance income, rent collected, legal judgments awarded, royalties, and any other income.

Total debt service

Next, you’ll figure out your total debt service, which is the total amount of debt that you pay each year. To calculate your total debt service, you’ll add up your estimated new monthly mortgage payment (including property taxes and homeowners insurance, if you know those costs) credit card bills, auto loans, student loans, and any other monthly payment and multiply by 12.

Total Debt Service = Total Monthly Debts x 12

If you’re calculating on behalf of a business, keep in mind that businesses take on a wider range of debts each year. Their total debt service would include the cash flow needed to cover salaries, business taxes and other operating expenses.

An example of the DSCR formula in real estate

Here’s an example for a home buyer who doesn’t own a business. Imagine a prospective scenario in which you wish to buy a $225,000 home:

• You make a down payment of $25,000. Doing so leaves you with a remaining mortgage of $200,000.
• You then decide to take out a 30-year fixed-rate loan.
• The interest rate on your loan is set at 6.25%.

Taking these factors into account, it means that you’ll have a monthly payment, not including property taxes or homeowners insurance, of around $1,231.

However, note that there are other factors that you will also need to take into account in order to calculate your DSCR.

• Your estimated property taxes are $6,000 a year ($500/month)
• Homeowners insurance is $2,400 annually ($200/month)
• You have a monthly car payment of $300
• You have also taken out a student loan that adds $300 a month

After crunching the numbers, your yearly debt would be equal to $30,372. If your total annual income is $80,000, this effectively means that your debt service coverage ratio would be 2.6 ($80,000 divided by $30,372). Most lenders would be comfortable approving you for this mortgage because your DSCR is much higher than 1.25 – which, in effect, means that from their perspective, you have ample ability to comfortably pay off the loan.

FAQS about DSCR and debt service

Answers to your most frequently asked questions about DSCR and debt service as it relates to your mortgage eligibility can be found below.

Is total debt service the same as total debt?

Yes, total debt service represents the total amount of debt that you have on a monthly or yearly basis.

How is DSCR different from DTI?

DSCR and DTI are both figures that represent your debt obligations compared to your total income, and provide lenders with a snapshot of your potential ability to meet a financial commitment. However, DTI is usually only used in real estate, whereas the debt service coverage ratio can be useful in both real estate and business.

What is considered a good DSCR?

The minimum DSCR required to be eligible for a loan will vary depending on the individual lender, but many lenders expect you to have a DSCR above 1.1 or 1.25. Anything closer to 1.0 or below it would show lenders that you’re potentially at a higher risk of not making your mortgage payments. The higher the DSCR, the better your chances of mortgage approval.

What does 1.25 debt service coverage mean?

If your debt service coverage ratio is 1.25, or 125%, that means your net operating income is 125% of your debt obligations. In other words, you appear to have the capability to readily pay off all your debts, with additional cash left over.

How can I increase my DSCR?

To increase your DSCR, you’ll need to either increase your net operating income or reduce your total debts. You can do this by paying off other debts or adding a second stream of income before applying for a mortgage.

The bottom line: why lenders use the DSCR formula

To protect its investment and protect home buyers from taking on more debt than they can potentially shoulder, a lender will only issue mortgages to borrowers whose DSCR figures show that they can afford their monthly housing payments. That’s where debt service comes in. If you have too much debt for your gross annual income, you might struggle to get approved for a mortgage loan.

Feeling good about your finances and ready to buy your dream home? Get started with Rocket Mortgage® and see what mortgage options you’re eligible for today.