What Is Total Debt Service And The Debt Service Coverage Ratio (DSCR)?

Your three-digit FICO^® credit score is a key number when applying for a mortgage. If that score is too low, lenders will hesitate to approve you for a mortgage. But did you know that your total debt service is another important financial factor that will determine whether you qualify for a mortgage?

Let’s talk about what total debt service is in real estate and how to calculate it.

What Is Total Debt Service?

Your total debt service is the amount of money you need to fully repay your debt during a certain period of time. You can calculate your total debt service for a month, a year or any other time frame. It measures the percentage of your gross annual income – your yearly income before taxes are taken out – that you need to make your loan payments and cover your other yearly debts. It’s similar to your debt-to-income ratio (DTI) in that it analyzes how much of your income is consumed each month, or year, by your debt obligations.

A higher amount of debt means you’ll have to spend a greater percentage of your gross annual income on paying it off. If you want to borrow money, it’s best to have a lower total debt service. This will make lenders feel more confident you can afford to pay your new monthly loan payment.

What Is Debt Service’s Significance In Real Estate?

Lenders are cautious when approving mortgage loans. They want to make sure borrowers can afford to make their monthly debt payments on time. Debt service calculations help with this task. If borrowers’ debts already consume too much of their gross monthly income, lenders will be more hesitant to approve them for a mortgage.

What Is The Debt Service Coverage Ratio (DSCR)?

The DSCR, or debt service coverage ratio, measures how much of your income particular debts consume. Mortgage lenders, for instance, want to know how much of your income would go toward paying off your housing costs.

Housing expenses include your estimated new mortgage payment, including principal, interest, property taxes, homeowners insurance and HOA fees, if you have them.

Lenders will consider you more of a risk to miss your mortgage payments if you’re spending too much of your income on housing costs. If you’re spending 50% of your income on housing, you're far more at risk of missing payments than if you’re spending just 20% on these costs.

If a new mortgage payment would result in spending too much of your income on housing costs, lenders will be more likely to reject your mortgage application. 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 mitigate some of the risk they’re 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 formula looks like this:

DSCR = Net Operating Income / Total Debt Service

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

The higher your DSCR, the healthier it is, and the more successful you’ll likely be with your loan. Lenders may have different minimum DSCR requirements, but you can expect a lender to set a minimum DSCR around 1.1 – 1.25.

As you can see in the equation above, you’ll need to know a few other numbers – 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 find the total amount of income 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 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.

Once you have your NOI (or annual gross income) and your total debt service (your total annual debt), you can calculate your own annual DSCR.

Here’s a real estate example for a home buyer who doesn’t own a business.

An Example Of The DSCR Formula In Real Estate

Say you want to buy a $225,000 home. If you make a down payment of $25,000, you’re left with a mortgage of $200,000. If you take out a