In the lending industry, metrics like the debt service coverage ratio (DSCR) are essential to evaluate borrowers’ ability to service loans. Lenders, financers, or investors can use the DSCR to determine if individuals or businesses can afford to pay back loans based on factors like their income and recurring expenses.
According to the Q2 2023 Report on Household Debt and Credit issued by the Federal Reserve Bank of New York, the current total American household debt soared as high as $17 trillion. While over $12 trillion of this consumer debt comprises outstanding mortgages, credit card balances account for $1 trillion of the total.
These statistics underpin the ever-growing importance for lenders to understand lending risks and make smart decisions. A metric like DSCR helps lenders avoid disbursing loans to borrowers whose existing debt obligations might impact their ability to service the loan in the long term. Supporting these KPIs is simple with an advanced loan origination software with automated loan decisioning, which we will cover in more detail.
Understanding Debt Service Coverage Ratio (DSCR)
By definition, the debt service coverage ratio is a metric that defines a borrower’s creditworthiness, informing lenders whether the borrower generates sufficient income to service a loan. The DSCR is the ratio of a borrower’s net operating income to total debt obligations.
Here, net operating income refers to the borrower’s income/revenue, less certain operational expenses.
A DSCR over 1.0 indicates that a borrower generates an adequate net operating income to sustainably service a new loan. On the other hand, a DSCR lower than 1.0 points to much higher debt than net operating income and, therefore, a higher likelihood of one’s inability to pay off a loan.
What Is a Good DSCR?
In general, a DSCR number over 1.0 demonstrates that a borrower can pay off a new loan with minimal default risk. However, many financial institutions are more comfortable with a DSCR at or over 1.25. Naturally, that would imply a borrower has sufficient means to take on more debt.
Of course, risk appetites vary from one lender to another. When building out their loan portfolios, lenders must determine what DSCR makes sense for their lending infrastructure.
Why DSCR Is Crucial in Assessing a Borrower’s Ability to Service Debt
For any lender, calculating DSCR when evaluating a borrower’s ability to service a loan helps gauge whether the borrower generates enough residual income to sustainably service the loan. For instance, a DSCR of 1.5 indicates that a potential borrower is making 150 percent more than is necessary to pay back their outstanding obligations.
The Importance of DSCR in Loan Origination
Developing a reliable workflow for calculating DSCR during loan origination will help you process loan applications faster, streamline underwriting, and accurately score risk on various loan products—satisfying auto, consumer, and commercial loan applicants.
Fuse’s loan origination system (LOS) enables lenders of any scale to automate their existing lending workflows and improve their business value. Whether you are a bank, credit union, or other financial institution in the lending business, Fuse provides a scalable, customizable, and simplified LOS with over 100 integrations to help you stand out within a competitive lending market.
When you adopt Fuse, features like DSCR calculation are already integrated into the platform, meaning you can instantly start automating your loan application processing.
With Fuse, you can unlock an infinite number of relevant data points beyond DSCR to gain a more comprehensive understanding of borrower profiles. Enriching loan application processing workflows with these types of data reduces bias and enables more accurate risk scoring across borrowers.
Schedule a demo to see Fuse in action.
Federal Reserve Bank of New York. Q2 2023 Report on Household Debt and Credit. https://www.newyorkfed.org/microeconomics/hhdc
Forbes. Understanding The Debt Service Coverage Ratio—The Backbone Of Commercial Real Estate. https://www.forbes.com/sites/forbesbusinesscouncil/2022/07/22/understanding-the-debt-service-coverage-ratio-the-backbone-of-commercial-real-estate/?sh=4e5ebb9f704b