Debt Service Definition

What is Debt Service?

Debt Service is the amount of money needed to cover the regular, recurring loan payment (both principal and interest) for an outstanding loan.

REtipster provides real estate guidance — not tax or investment advice.

This article should not be interpreted as financial advice. Always seek the help of a licensed financial professional before taking action.

Debt Service Explained

Debt Service is the amount of money needed to cover the regular, recurring loan payment (both principal and interest) for an outstanding loan.

The term is often used by bankers, accountants, and other financial professionals because it can be used to refer to ALL of a borrower’s outstanding loan payments.

For example, when a loan officer or credit analyst asks,

“What’s the monthly debt service on this loan?”

They’re referring to the total amount of monthly loan payment(s) a borrower or loan applicant is obligated to pay.

When underwriting a loan, lenders can use this number in conjunction with the loan applicant’s operating income to determine the debt service coverage ratio (DSCR), which is a basic and critical component of proper credit analysis.

What is a Debt Service Coverage Ratio?

Debt service coverage ratio (often abbreviated DSCR) is a simple formula that compares a loan applicant’s net operating income to its debt service during a set time period (usually monthly or annually). It’s an expression of a business’s cash flow and ability to cover its debt obligations.

Here’s a simple example:

If a business generates $500,000 in net operating income and the annual debt service is $400,000, the debt service coverage ratio would be 1.25.

$500,000 / $400,000 = 1.25 DSCR

In other words, for every $1 of debt service, the business will have $1.25 available to pay it.

Debt service coverage ratio is a key factor in determining whether an investment property will generate enough cash flow to cover its debt service because it shows the total amount of net operating income that will be available for every dollar of debt service.

Bonus: Get a FREE copy of the INVESTOR HACKS ebook when you subscribe!

Free Subscriber Toolbox

Want to learn about the tools I’ve used to make over $40,000 per deal? Get immediate access to videos, guides, downloads, and more resources for real estate investing domination. Sign up below for free and get access forever.

How to Calculate the Debt Service Coverage Ratio

There are some common misunderstandings about how underwriters calculate the debt service coverage ratio during the loan approval process.

Investors tend to look only at gross potential rents and PITI (principal, interest, taxes, and insurance) when they estimate net operating income.

For example, if you want to buy a fourplex for $400,000, your annual assumptions might look like this:

Income:

  • ($1,000/monthly rent x 4 units) x 12 months = $48,000 gross potential rent

Expenses:

  • $2,600 monthly principal and interest x 12 months = $31,200 debt service
  • Property Taxes of $3,600
  • Property Insurance of $1,800

$31,200 debt service + $3,600 property taxes + $1,800 property insurance = $36,660 Total Expenses

DSCR:

($48,000/$36,660) 1.31

However, gross potential rent isn’t the most realistic portrayal of a property’s earning potential, because it assumes 100% occupancy and no late or missed payments from the tenants.

As this article from Sapling explains,

Gross potential rent (GPR) is the total amount of income a real estate investor can expect to receive from a purchased property based on “market rent.” To determine the GPR, the investor assumes that all of his units are occupied and that each tenant pays all of his rent. Another term used for GPR is gross potential income.

Astute underwriters will apply certain assumptions to the calculation to bring expenses in line with the local market. They will hold back a percentage of gross potential rents to cover vacancies and collection and add repairs, maintenance, and replacement reserves to your expenses to calculate net operating income.

The underwriter’s numbers for the property might look more like this:

Income:

  • ($1,000/monthly rent x 4 units) x 12 months = $48,000 gross potential rent
  • Holdback for vacancies and collections (7%) – $3,360

$48,000 gross potential rent – $3,360 holdback = $44,640 Total Income

Expenses:

  • Property Taxes of $3,600
  • Property Insurance of $1,800
  • Repairs and Maintenance of $1,000 ($250/unit)
  • Reserves of $2,000 ($500/unit)

$3,600 property taxes + $1,800 property insurance + $1,000 Repairs and Maintenance + $2,000 Reserves = $8,400 Total Expenses

$44,640 Income – $8,400 Expenses = $36,240 Net Operating Income

Debt Service:

  • $2,600 monthly principal and interest x 12 months = $31,200 debt service

Underwriter’s DSCR:

$36,240 Net Operating Income / $31,200 Debt Service = 1.16

The underwriter’s calculation shows that the building’s cash flow is 116% of the annual debt payments, which gives us  a debt service coverage ratio of 1.16.

An investor should know that this underwriting metric is a good way to compare potential properties and estimate their cash flow. It may not, however, accurately reflect how your lender will calculate it for their credit decisions.

What is a "Good" Debt Service Coverage Ratio?

A DSCR of 1.0 is the break-even point, so if the analysis shows that a business or investment property is coming in below 1.0, they are officially operating at a loss and not generating enough income to cover their debt service.

Those above 1.0 show positive cash flow, however, a lender will look for a DSCR in excess of 1.0 to show that the borrower has sufficient cash flow to cover their debt service even if there is an unexpected drop in net operating income.

The right amount of “cash flow cushion” depends on the type of business, the risk appetite of the lender, the condition of the market and a lot of other factors, so there isn’t one correct amount that applies to all borrowers, but generally speaking, most asset-based lenders will want to see a DSCR of 1.20 or higher. A business or investment property with a DSCR of 1.5 – 2.0 or higher may have a case for obtaining preferential rates on their loan, at the discretion of the lender.

Debt Service, LTV and Other Factors

DSCR is one of many metrics that are evaluated by lenders when approving a loan and evaluated by investors before closing on an investment property, but it goes without saying, a higher DSCR will only serve to strengthen the deal in the eyes of a lender or investor.

Lenders will often weigh both the Debt Service Coverage Ratio (DSCR) and Loan to Value (LTV) to help determine the final loan amount.

For example, if underwriting requires a maximum LTV of 80%, but the DSCR is below underwriting requirements with an 80% loan, the lender may decrease the loan amount until the DSCR moves into the acceptable range.

Debt service coverage ratios aren’t set in stone; each lender has its own guidelines on what’s acceptable for a given property, industry, and loan type. One lender may approve an 80% loan with a 1.20 DSCR; another may only lend 70%.

Ultimately, the debt service coverage ratio is a useful formula that real estate investors can use to compare different properties and see how they fit into their investment strategy and portfolio. It also helps as a gauge for financing options when an investor is shopping for asset-based lenders.

The Best Real Estate Investing Strategy I’ve Found

The most powerful strategy I've used to build my real estate investing career is NOT what you might guess.

Land investing (that's right, buying and selling vacant land) is a massive opportunity that most investors aren't paying attention to. For the few land investors who know how to pursue this business with the right acquisition strategy, it's an extremely lucrative and low-risk way to build serious wealth from real estate.

If you want to get the inside scoop on how to start and run your own land investing business, come and check out the Land Investing Masterclass – where I've put together a full 12-module course with dozens of videos, bonuses, downloads, group coaching sessions and a members-only forum (where we spend time answering questions every week). There is no better place to learn this business from the inside out!

Did you find this article to be helpful?

Our goal is always to provide our readers with the most up-to-date and relevant content so that we can continue to empower others! Please share your feedback.

Bonus: Get a FREE copy of the INVESTOR HACKS ebook when you subscribe!

Free Subscriber Toolbox

Want to learn about the tools I’ve used to make over $40,000 per deal? Get immediate access to videos, guides, downloads, and more resources for real estate investing domination. Sign up below for free and get access forever.

Scroll Up

Welcome to REtipster.com

We noticed you are using an Ad Blocker


We get it, too much advertising can be annoying.

Our few advertisers help us continue bringing lots of great content to you for FREE.

Please add REtipster.com to your Ad Blocker white list, to receive full access to website functionality.

Thank you for supporting. We promise you will find ample value from our website.