The mortgage constant, also known as the loan constant, the debt constant, or the mortgage capitalization rate, is an important concept to understand in commercial real estate finance. Yet, it’s commonly misunderstood. In this article, we’ll take a closer look at the mortgage constant, discuss how it can be used, and then tie it all together with a relevant example.
What is The Mortgage Constant?
First, what exactly is the mortgage constant? The mortgage constant, also known as the loan constant or the debt constant, is defined as annual debt service divided by the loan amount. Here is the formula for the mortgage constant:
Mortgage Constant = Annual Debt Service / Loan Amount
In other words, the mortgage constant is the annual debt service amount per dollar of loan, and it includes both principal and interest payments.
How to Calculate the Mortgage Constant
There are two commonly used methods to calculate the mortgage constant. The first simply divides annual debt service by the total loan amount. The second allows you to calculate the mortgage constant for any loan amount by solving for the payment based on a loan amount of $1. Let’s take a look at both methods.
Example Calculation of Mortgage Constant
Suppose we have a $1,000,000 loan based on a 6% interest rate and a 20-year amortization. With this information, you can simply find the annual debt service using the above assumptions, then divide the annual debt service by the loan amount.
On our financial calculator, if we plug in 240 months for N, -$1,000,000 for PV, .50% for I (6%/12), and 0 for FV, then we can solve for the monthly payment. To convert this to an annual payment amount, we simply multiply by 12. Note that when you carry out the decimal 2 places you get a monthly payment of $7,164.31, which equals $85,971.73 when multiplied by 12.
Since the mortgage constant is simply the ratio of annual debt service to the total loan amount, this calculation is just a simple division. In this case, we take $85,972 / $1,000,000 to get a mortgage constant of 0.085972. As a percentage, this would be 8.5972%.
Calculating for Any Loan Amount
The method above works if you already know the loan amount, but what if you want to find the mortgage constant for any loan amount? If you only know the amortization period and the interest rate, then you can easily solve for the mortgage constant. This is accomplished by plugging this information into a financial calculator, while using $1 as the present value.
For example, consider the same loan terms above of a 20-year amortization (240 months) and a 6% interest rate (0.50% per month). Since we don’t know what the loan amount is (present value), we can use $1 as the present value:
When we solve for payment, we get 0.007164. Since this is a monthly payment, we can multiply by 12 to get an annual mortgage constant of .085972. Notice this is the same 8.5972% mortgage constant we found above.
Conclusion
So, we have two different approaches to calculate the mortgage constant that will give us the same result. Understanding the mortgage constant is crucial for real estate professionals, as it plays a key role in evaluating financing options and investment properties. Whether you’re working with a specific loan amount or trying to understand the implications of varying interest rates and amortization periods, grasping this concept will enhance your financial acumen in real estate.
