What’s the difference between Interest Coverage Ratio and DSCR?
Banks use a few different methods to work out your ability to afford a commercial property loan or business loan.
The most common way is using the Interest Coverage Ratio (ICR) method because it doesn’t take into account expenses that are tax deductible.
ICR is also known as 1.0x cover or 1.5x cover because it determines how many times your income or business earnings before interest and taxes (EBIT) cover your interest expenses over the same period.
How is ICR used to determine your borrowing power?
Firstly, the bank will apply an assessment rate, a rate that’s higher than the standard commercial rate they offer.
For example, if the rate is 4.50%, they’ll assess you at 8.50%.
Secondly, they’ll work out your gross available income but will only use a percentage depending on the source of the income.
As a general rule, the bank will consider the following percentages:
- Income from a job: 100%
- Business income: 100%
- Residential investment properties: 80% of rental income
- Commercial investment: 65% if landlord pays outgoings and 85% if tenant pays outgoings.
From this, they will minus your expenses, including:
- Your commercial or business loan at the assessment rate but just the interest payable (the principal payments are ignored).
- The principal and interest owing on any existing debts.
- Living expenses and tax are typically ignored for the ICR method because they are deductible expenses.
Example Interest Coverage Ratio method
James is earning $100,000 p.a. from his plumbing business and $100,000 rent income from a commercial property where his tenant pays the outgoings (taken at $85,000).
He wants to borrow $1,000,000 to buy a factory as a commercial investment.
His lender is offering a variable rate of 4.50% but they will actually assess his borrowing power based on an assessment rate of 8.00%.
To work out James’ ICR, the bank uses the following formula:
$185,000 EBIT / $80,000 in interest payments = 2.31x interest cover
So what does 2.31x interest cover mean for James’ ability to borrow?
What is a strong ICR?
Lenders need confidence that there’s a large enough buffer in place should you face financial difficulty or if there were to be a sudden change in the economy.
As a general rule:
- 1.0x cover barely passes and is acceptable only to some lenders.
- 1.3x cover minimum acceptable for most banks.
- 1.5x cover is considered acceptable.
- 2.0x cover is considered to be a strong application since you can effectively pay the interest on the loan twice.
Why is ICR used in commercial lending?
The reason that Interest Coverage Ratio is used in commercial lending all has to do with tax.
All interest and most living expenses are tax deductible in commercial and business operations.
In essence, they’re not really expenses that need to be factored in for professional investors or business owners.
Of course, you still need to be in a strong financial position with good cash flow in order to qualify for a commercial loan.
Speak with one of our mortgage brokers about your commercial or business loan needs by calling 1300 889 743 or by filling in our free assessment form today.
We can let you know if you qualify!
ICR vs Net Surplus Ratio and Debt Service Ratio
Interest Coverage Ratio is the most common method used in commercial lending because it makes the most sense from a tax perspective.
Net Surplus Ratio (NSR) factors in living expenses and tax so it’s a little more comprehensive than ICR when calculating the affordability of the loan to your financial situation.
This method is used in residential lending rather than commercial.
Debt-Service Coverage Ratio (DSCR) is an outdated method compared to ICR, taking a more conservative approach when calculating your income.
Although it depends on the lender, DSCR assumes that 30%-50% of your income can be used to pay debts while 30% approximately is allocated to pay tax.
It’s not useful where loans are tax deductible and is more often used for residential loans.
It shouldn’t actually be used for residential investment loans either but some lenders still rely on it.
We can help find you a lender that takes a more common sense approach to your Net Operating Income (NOI).
In that way you can borrow more for your commercial property loan or for any business finance you were after including invoice discounting or trade finance.
Need a loan? Complete our online enquiry form or speak with one of our brokers by calling 1300 889 743.