What is Debt Service?
Debt Service is the total principal and interest payment owed on a financial obligation, such as a commercial mortgage loan, expressed on an annual basis.
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How to Calculate Debt Service in Real Estate
Debt service in the real estate industry refers to the burden placed on a borrower after committing to a financing arrangement.
The borrower is contractually obligated to service periodic interest and principal payments to the lender once the lending agreement has been formally signed by both parties – including the repayment of the original principal in full at maturity.
From the perspective of commercial lenders, such as banks, debt service is one of the most critical factors to consider when underwriting a loan.
The borrower of a commercial mortgage loan must service its interest and principal payment obligations on time, per the lending agreement.
Otherwise, the borrower is at risk of defaulting on the commercial loan and becoming insolvent. In the event of default, the lender most likely would have the right to seize the property based on the terms as outlined in the original agreement to recoup any monetary losses.
Senior lenders normally require the borrower to pledge the underlying real estate property as collateral to further protect their downside risk (i.e., a lien).
While the borrower is held liable in the event of default, the lender must still actively mitigate risk by performing in-depth diligence on the credit profile of the borrower (and property).
Debt service comprises the periodic principal amortization and interest owed on a loan.
- Principal → The principal amortization refers to the incremental repayment of the original loan principal.
- Interest → The interest expense is the cost of financing and reflects the borrower’s perceived credit risk (i.e. higher risk coincides with a higher interest rate, and vice versa).
Debt Service Formula
The formula to calculate the annual debt service is the sum of the principal payment and interest expense in a specified period.
In practice, the annual debt service is most often calculated in Excel, as part of building a loan amortization schedule.
The amortization schedule is a method used to track and calculate the periodic principal amortization and interest owed on a loan, including the outstanding loan principal balance.
The annual debt service can be determined via the built-in PMT function in Excel, which calculates the periodic payment on a loan, inclusive of the interest and principal component.
The two components of the annual debt obligation — the principal and interest payments — can be separately calculated using the PPMT and IPMT function, respectively.
The sum of the principal and interest computed using the PPMT and IPMT function must equal the debt service determined by the PMT function, or else a mistake was likely made.
- PPMT Function → Principal Payment
- IPMT Function → Interest Payment
- PMT Function → Principal Payment + Interest Payment
Maintaining consistency in the units is critical to ensure the accuracy of the payment amounts (i.e. monthly, quarterly, semi-annual, annual).
Note: The PMT, PPMT and IPMT Excel functions each assume a fixed interest rate pricing structure on the loan.
