Most commercial lending can be boiled down to the results of three ratios:
- Debt Service Coverage Ratio (DSCR)
- Loan-To-Value Ratio
- Debt Ratio
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 Debt Service Coverage Ratio (DSCR) is a sophisticated ratio used for income producing properties and businesses/franchises. Debt Service Coverage Ratio equals net operating income divided by debt service. 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 are 1.25 and greater depending on the commercial property. A debt service coverage ratio is 1.0 , it says the rental property income or the business can only cover the mortgage payment. If the debt service coverage ratio is less than 1.0would mean that the property or the business did not produce enough income for the owner to make the mortgage payments without supplementing the property from his personal budget.
The second ratio is typically used by local banks or if you are trying for an Small Business Administration loan. The Debt Ratio compares the amount of bills that the borrower must pay each month to the amount of monthly income he or she earns. More precisely, the Debt Ratio equals the monthly debt obligations divided up the monthly income.
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 Loan-To-Value Ratio (LTVR) equals the total loan balances divided up the fair market value (as determined by appraisal). Investment property Loan-To-Value Ratios seldom exceed 70% to 80% depending on the type of investment property. Owner occupied Loan-To-Value Ratios seldom exceed 80% to 90% depending on the type of owner occupied property. Commercial lender always want some extra protection against default.
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