Figuring out whether a mortgage is a good deal takes a lot of time and number crunching. There are plenty of variables to keep in mind, particularly with loans since these instruments accrue interest over time. A mortgage constant is a number you can reach by calculating a few variables for a proposed loan agreement, and by finding it, you can determine whether a mortgage (or any other loan) will be a good investment. Let's break it down.
A mortgage constant (which can also be called a loan constant, a debt constant, or the mortgage capitalization rate) is the percentage of the annual debt service for a loan when compared to the total principal value. Debt service is any cash needed to cover repaying interest and principal for a debt for a certain period of time.
Put another way, a mortgage constant is how much annual debt service you have divided by your original loan amount.
The basic mortgage constant loan formula breakdown looks like this:
- mortgage constant = annual debt service / loan amount
What does this mean in layman's terms? The mortgage constant is your annual debt service per every dollar of a loan, or:
- mortgage constant = how much money you pay annually for a loan's total amount
This is useful since it includes both interest and principal payments for a loan.
Real estate borrowers can compare mortgage constants for different loans before making a final decision. Loans that have lower mortgage constants have lower debt service requirements, so the borrower will pay less in both principal and interest over the loan period. Note that mortgage constants are only applicable to fixed-rate loans, not variable.
As you might imagine, mortgage constants and their applicable calculators are great if you want to calculate mortgage payments or are figuring out which loan will be best for your needs.
Since the mortgage constant is expressed as a percentage, it's usable for any type of loan.
Follow the formula above and divide the projected annual debt service by the total loan amount.
For instance, if there is a mortgage borrower (i.e., someone wants to buy a house) who has a $150,000 loan, they might find that the loan it comes with has a fixed interest rate of 6%. The loan comes with a 30-year duration and includes monthly interest payments.
Based on the above information, monthly payments for this loan would be $899.33. Annual debt service (the amount needed to pay for a loan's principal and interest over 12 monthly payments) would, therefore, be $10,791.96.
Thus, you can plug all the numbers into the formula:
- $10,791.96 / $150,000 = 0.0719 or 7.2%
So the mortgage constant is 7.2%, or the borrower would pay 7.2% of the loan's amount to cover both interest and principal each year (which still has them fit into the 30-year timeframe).
Loan or mortgage constants, so long as they are correctly multiplied by the original loan's principal, will always provide the real dollar amount for your periodic annual payments expressed in a percentage. This is a great tool you can use to figure out the actual cost of borrowing with a given loan agreement.
In this way, you can use mortgage constants (or loan constants for other types of loans) to figure out what loans are better for your financial situation. Lower loan constants are usually better because they have lower debt service requirements. Think of mortgage constants as a way to cut through the complicated math and boil things down to a single actionable number.
For instance, lenders can use the mortgage constant to figure out if the property would be suitable for a multifamily or commercial loan. In this way, such constants are pretty similar to cap rates for lenders, especially since both tools are pretty similar in terms of their formula composition.
In fact, it's a great idea to compare the loan constant and cap rate for a given property if you want to figure out whether it'll be profitable in the long term. Properties that have loan constants that exceed the cap rate are likely to lose money. In addition, properties that have higher cap rates than loan constants are expected to make money.
Take this example:
- say you have a property with a 20 year, fully amortizing loan for $2 million with a 5% interest rate
- this will incur $158,389 every year in total payments
- the loan constant, using the above formula, is 7.9% - $158,389/$2 million = 7.9%
Now, if you presume that the property above is making $185,000 a year in net operating income or NOI, you can figure out the cap rate with this formula:
- $2 million / $185,000 = 10.8%
10.8% is higher than 7.9%, so such a property is likely a good investment.
These are tables you can find on many online resources that come with premade or precalculated information for borrowers to help them figure out their mortgage constants quickly and easily. They're essentially solution tables where you plug in your principal, interest rate, and so on, then read the chart for a mortgage constant answer.
Just because mortgage constants/loan constants can be valuable doesn't mean they should be applied to every situation. For instance, you can't use mortgage constants for variable-rate mortgages at all, or for any adjustable loans. The change in interest rates as the loan progresses means that you won't be able to figure out an accurate mortgage constant.
The fact that loan constants calculate for both interest and for principal amounts means that you can't apply the loan constant formula to any interest-only loans.
Overall, the mortgage constant is a very commonly used calculation tool in real estate investment. It's an excellent pick if you have a fixed-rate loan or need to compare multiple loans against one another to figure out which will be a better choice. It's also a great idea if you want to figure out the suitability for a residential or commercial property for a big loan. Good luck!