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Ever wonder why banks shy away from loans that appear to be relatively
conservative?
There are numerous reasons banks
avoid making loans that, in general,
one would think have a high likelihood
of paying back. According to a banker
who works for a well known bank,
during the mortgage crisis of almost a decade ago, one
thread seem to run through all of the bad loans on the bank’s
books; late payments on even the smallest of items, such as
a department store credit card. This type of information led
banks to steer away from otherwise good borrowers [after the
mortgage meltdown], since the banks did not want to have
borrowers who tended to be late or default on mortgages. Thus,
a borrower who
never missed a mortgage payment but may have been late on a small credit card was seen as a bigger
risk for a future default on a mortgage should there be instability in the economy.
Banks are not in the business of taking over property and do not want to be seen as predatory lenders.
Even if a borrower has a “good story”, banks would rather not even entertain a loan, which, on its
surface, appeared to be more likely to fall into default. Banks are very cash flow oriented. They do not
want to lend to borrowers where there may be a question of how a mortgage will be serviced. In
commercial real estate loans, banks use a ratio called DSCR [Debt Service Coverage Ratio]. The
DSCR is a measure of the cash flow available to pay current debt obligations [principal and interest in
cases of a mortgage]. It shows the ability to produce enough cash to cover the mortgage payment. In
previous years [before 2007], most banks required a DSCR of at least 1.1. For example, if the
mortgage payment [including principal and interest] was $10,000 per month, the net cash flow [after
paying normal expenses and before the mortgage] needed to be at least $11,000 per month. This was
not usually an undue burden, as most real estate investors would have expected to have at least a
break even cash flow after paying the mortgage. However, after 2007, almost every bank in the nation
tightened up their standards to where they insisted on a DSCR of at least 1.25 and as high as 1.35.
Although this may not seem excessive, the extra 15 to 25 basis point requirement severely restricted
one’s ability to borrow. The investor found would have to put down a much larger down payment
[thereby a lower loan needed] on the property in order to satisfy a much higher DSCR. Many real estate
investors did not possess the mandated down payment and found they could not qualify for the new
higher DSCR.