What is Mortgage Constant?
The Mortgage Constant measures the annual debt service on a fixed-rate loan relative to the total principal amount, expressed as a percentage.
The mortgage constant, or “loan constant”, therefore represents the percentage of the debt service obligation on an annualized basis, in relation to the original loan size.
How to Calculate Mortgage Constant
The loan constant is a method used to understand the annual financial commitment of a borrower to service a loan priced at a fixed rate.
The mortgage constant, or “loan constant”, is a real estate metric used to determine the annual debt obligation of a fixed-rate loan relative to its total size.
Therefore, the mortgage constant is a financial ratio that compares the annual debt service – interest expense plus principal amortization – to the total loan amount.
By comparing the annual debt service to the total loan amount, the annual debt burden placed on a particular borrower from the loan can be analyzed to estimate the credit risks attributable to the borrowing.
The loan constant applies only to fixed-rate commercial loans and mortgages.
Why? The annual debt service for adjustable or variable-rate loans is unpredictable because the debt payments fluctuate based on the underlying prime rate – albeit, the loan constant could technically be computed for the “locked-in” period, wherein the interest rate remains constant.
The mortgage constant is calculated as the ratio between the annual debt service and the total loan amount, expressed as a percentage.
- Annual Debt Service → Interest Expense + Principal Amortization
- Total Loan Amount → Gross Size of the Mortgage Loan
Once the two inputs on a specific fixed-rate financing arrangement have been determined, the annual debt service is divided by the total loan amount to calculate the mortgage constant.
Mortgage Constant Formula
The formula to calculate the mortgage constant (or loan constant) is as follows.
Where:
Since the mortgage constant is normally expressed as a percentage, the output must then be multiplied by 100 to convert the result into percentage form.
The relationship between the annual debt service and total loan amount must be grasped by both parties in the lending agreement – the borrower and the lender – to mitigate credit risk (and the risk of default).
- Lender → The lender must prioritize capital preservation and reducing downside risk (i.e. limiting losses incurred in the event of default). Hence, it is necessary to right-size the loan based on the credit profile of the borrower at issuance.
- Borrower → The borrower must make sure the annual debt service is at a manageable level and aligns with the expected income of the property. Otherwise, the collateralized property will be seized post-default as stated in the terms of the lending agreement, i.e. in a property foreclosure.
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We’ll now move on to a modeling exercise, which you can access by filling out the form below.
Loan Constant Calculation Example
Suppose we’re tasked with calculating the mortgage constant on a fixed-rate commercial loan with the following lending terms.
Commercial Loan Financing Assumptions
- Commercial Loan Amount = $600,000
- Loan Term = 25 Years
- Annual Interest Rate (%) = 6.00%
- Monthly Interest Rate (%) = 0.50%
- Payment Frequency = 12.0x
- Number of Periods = 300 Periods
Starting off, we’ll determine the annual debt service by calculating the sum of the interest and principal amortization paid annually toward the commercial mortgage loan.
But since the structure of our debt schedule is on a monthly basis, we must then multiply the debt service figures by twelve to annualize the figures.
The annual debt service of $3,866 was determined using the PMT Excel function:
Therefore, by dividing the annual debt service by the total loan principal at issuance, we arrive at a loan constant of 7.73%.
- Loan Constant (%) = $3,866 ÷ $600,000 = 7.73%
Since the commercial loan is priced at a fixed rate, our debt schedule illustrates how the loan constant remains unchanged until the maturity date.
The “Interest” and “Principal” columns in our loan amortization schedule were calculated using the IPMT and PPMT Excel functions, respectively.
The annual debt service – the sum of the principal and interest payments – equals $3,866 each month, as that is how the mechanisms of fixed-rate loans work.
Briefly, interest should contribute a greater proportion of the annual debt service in the initial periods, but gradually decline as more of the principal is paid off.
In conclusion, we’ll confirm that the column tracking the remaining loan balance declines to zero at maturity, and insert a “check” that makes sure that the total principal paid over the lending term is $600k.
