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.
Table of Contents
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.
