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.
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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.
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.
The formula to calculate the mortgage constant (or loan constant) is as follows.
Mortgage Constant (%) = Annual Debt Service ÷ Total Loan Amount Annual Debt Service = Interest + Principal AmortizationSince 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).
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We’ll now move on to a modeling exercise, which you can access by filling out the form below.
Suppose we’re tasked with calculating the mortgage constant on a fixed-rate commercial loan with the following lending terms.
Commercial Loan Financing Assumptions
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:
=-PMT(Monthly Interest Rate, Number of Periods, Commercial Loan Amount)
Therefore, by dividing the annual debt service by the total loan principal at issuance, we arrive at a loan constant of 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.
=IPMT(Monthly Interest Rate, Month Number, Number of Periods, Total Loan Amount) =PPMT(Monthly Interest Rate, Month Number, Number of Periods, Total Loan Amount)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.
