Mortgage Constant: How to Calculate It and Why Lenders Care

The mortgage constant is one of the simplest numbers in commercial lending, and one of the most useful. It tells you what percentage of the loan amount you pay back each year in principal and interest combined. Lenders use it to size loans, and investors should use it to check whether a deal actually works with debt on it.

What Is a Mortgage Constant?

The mortgage constant, sometimes called the loan constant, is the annual debt service on a loan divided by the original loan amount. It is expressed as a percentage.

Mortgage constant = annual debt service / loan amount

Annual debt service is the total of all twelve monthly payments, principal and interest. Because it includes principal, the mortgage constant is always higher than the interest rate on an amortizing loan. On an interest only loan, the constant and the interest rate are the same.

How to Calculate It, Step by Step

First you need the monthly payment. The standard formula is:

Monthly payment = P x r / (1 minus (1 + r)^(negative n))

Here P is the loan amount, r is the monthly interest rate (annual rate divided by 12), and n is the total number of monthly payments.

Here is an illustration with round numbers. These are example figures, not a quote or a current rate.

1. Loan amount: $1,000,000
2. Interest rate: 6.5% a year, so r = 0.065 / 12 = 0.0054167
3. Amortization: 25 years, so n = 25 x 12 = 300 payments
4. Monthly payment: about $6,752.07
5. Annual debt service: $6,752.07 x 12 = about $81,025
6. Mortgage constant: $81,025 / $1,000,000 = 8.10%

So on this loan you pay about 8.1 cents per year for every dollar borrowed, even though the rate is 6.5%. That gap is the principal paydown.

Stretch the same loan to a 30 year amortization and the payment drops to about $6,320.68 a month, or $75,848 a year. The constant falls to about 7.58%. Raise the rate to 7.5% on the 25 year schedule and the constant climbs to about 8.87%. Rate and amortization both move the number, and amortization often matters more than people expect.

Why Lenders Care So Much

Most commercial lenders size loans off the property’s income, not just its value. The key test is the debt service coverage ratio, which is net operating income divided by annual debt service. Many lenders want to see something like 1.20 to 1.35, depending on the property and the lender.

The mortgage constant makes that math quick. If you know the NOI, the required coverage, and the constant, you can back into the largest loan the property will support:

Maximum loan = NOI / required DSCR / mortgage constant

Using the example above, say a building produces $110,000 of NOI and the lender requires 1.25 coverage. That allows $88,000 of annual debt service. Divide $88,000 by the 8.10% constant and the maximum loan is about $1,086,000. If the loan to value test would allow more, coverage is what limits the loan. In my experience that is often the case when rates are up.

Why Investors Should Care Too

The constant is a quick way to see whether debt is helping or hurting your return. Compare it to the cap rate on the purchase. If you buy at a 7% cap and your mortgage constant is 8.1%, every dollar you borrow costs more per year than that dollar earns from the property. Your cash on cash return will be lower than if you had paid more cash. That is called negative leverage, and it is worth knowing about before you sign, not after.

When the cap rate is above the constant, borrowing improves your cash flow return. When it is below, you are counting on appreciation, rent growth, or a future refinance to make the numbers work. Neither is automatically wrong. You just want to know which deal you are buying.

How This Plays Out in Kootenai County

A lot of the commercial deals I see in Coeur d’Alene, Post Falls, Hayden and Rathdrum are smaller industrial, flex, retail and office buildings. Those loans are often made by regional and community banks and credit unions. Their terms can vary quite a bit from one lender to the next, especially on amortization. A 20 year schedule versus a 25 year schedule can change the constant enough to change how much you can borrow.

When I run numbers on a building for a buyer, I calculate the constant for a couple of realistic loan structures and compare it to the cap rate. It is a two minute exercise that tells you a lot about whether a price makes sense with financing. Always confirm actual terms with your lender, since rates, coverage requirements and amortization change and differ by lender.

Quick Recap

• Mortgage constant = annual principal and interest / loan amount.
• It is higher than the interest rate on any amortizing loan.
• Lenders use it with NOI and DSCR to size the loan.
• Investors compare it to the cap rate to see if debt helps or hurts cash flow.

If you are looking at a building and want a second set of eyes on how the debt pencils, I am happy to run it with you. What loan terms are you seeing?