Most of real estate lending can be boiled down to the results of three ratios:
- Loan-To-Value Ratio (LTVR)
- Debt Ratio
- Debt Service Coverage Ratio (DSCR)
The bulk of the energy spent “processing” a loan is merely an attempt to verify the numbers that go into the numerator and denominator of the
above 3 ratios.
The Loan-To-Value Ratio (LTVR) is defined as follows:
Total loan balances (1st mtg+2nd mtg+3rd mtg)
Fair market value (as determined by appraisal)
Loan-To-Value Ratios seldom exceed 80% because the lender always wants some extra protection against default.
The second ratio that lenders use when “underwriting”: i.e., qualifying, a loan is the Debt Ratio. The Debt Ratio compares the amount of bills that the borrower must pay each month to the amount of monthly income he earns. More precisely, the Debt Ratio is defined as:
Debt Ratio =
Monthly Debt Obligations
Obviously someone whose Debt Ratio is 150% is in trouble. A Debt Ratio of 150% would mean that a borrower’s obligations are one and a half times his income. Debt Ratios seldom are allowed to exceed 40% in practice.
The final ratio used in lending is the Debt Service Coverage Ratio (DSCR). The Debt Service Coverage Ratio is a sophisticated ratio only used for large loans on income producing properties. It is defined as:
Debt Service Coverage Ratio =
Net Operating Income
where Net Operating Income is the income from a rental property after deducting for real estate taxes, fire insurance, repairs, and all other operating expenses; and Debt Service is the mortgage payment on the property. Most lenders insist that this ratio exceed 1.0. A debt service coverage ratio of less than 1.0 would mean that the property did not produce enough net rental income for the owner to make the mortgage payments without supplementing the property from his personal budget.
Each ratio will be covered in more detail in a separate memo.