Which ratio helps lenders manage risk in mortgage deals?

The debt coverage ratio (DCR) is an essential tool for lenders in managing risk related to mortgage deals. It measures a property's ability to generate enough income to cover its debt obligations, specifically the loan payments. By calculating the DCR, lenders can assess whether a borrower will likely generate sufficient cash flow from their property to meet their mortgage payments. A higher DCR indicates a greater capacity to cover debt service, which translates into a lower risk for the lender.

For instance, a DCR of 1.2 means that the property generates 20% more income than what is required to cover the mortgage payments, making it a safer investment for lenders. Conversely, a DCR below 1 (for example, 0.8) would suggest that the property's income is insufficient to meet debt obligations, highlighting a potentially risky proposition for lenders.

Other ratios, like gross profit margin or return on investment, focus more on profitability or overall business performance rather than specifically assessing income relative to debt obligations. The current ratio measures liquidity, which is essential for ensuring that an entity can meet its short-term obligations but does not provide a clear assessment of a property's ability to cover its mortgage specifically. Therefore, the debt coverage ratio is the most relevant for lenders to