Income Property Underwriting Manual - The Cornerstones of Real Estate Lending: Three Essential Ratios

Income Property Underwriting Manual - The Cornerstones of Real Estate Lending: Three Essential Ratios

In the realm of real estate lending, the assessment and approval of loans largely revolve around three pivotal ratios: the Loan-To-Value Ratio (LTVR), the Debt Ratio, and the Debt Service Coverage Ratio (DSCR). The primary focus during the loan processing phase is to authenticate the figures that form the basis of these three ratios.

Loan-To-Value Ratio (LTVR)

The LTVR plays a critical role in determining the feasibility of a loan. It is calculated as the total loan balances (including first, second, and third mortgages) divided by the property's fair market value, as assessed by an appraisal. Typically, lenders prefer that the LTVR does not exceed 80%, providing them a buffer against potential defaults.

Debt Ratio

This ratio is a key metric used by lenders to assess a borrower’s financial health. It is defined as the borrower's monthly debt obligations divided by their monthly income. A Debt Ratio exceeding 40% is uncommon, as it may indicate a borrower's financial strain. For instance, a Debt Ratio of 150% signifies that the borrower's debts are one and a half times their income, suggesting potential repayment difficulties.

Debt Service Coverage Ratio (DSCR)

Reserved mainly for larger loans on income-generating properties, the DSCR is a more complex ratio. It is the ratio of Net Operating Income (income from a rental property after expenses such as real estate taxes, insurance, repairs, etc.) to Debt Service (the property’s mortgage payment). A DSCR above 1.0 is generally desired, indicating the property generates sufficient rental income to cover mortgage payments. Conversely, a DSCR below 1.0 implies the property's income is inadequate to meet mortgage obligations without additional personal funding from the owner.

Each of these ratios will be explored in greater detail in separate memos, providing a more comprehensive understanding of their importance and application in the process of real estate lending.

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