Introduction
What Is a Mortgage Constant? A borrower's annual payment on a mortgage loan is measured by a real estate calculation called the mortgage constant. A constant mortgage calculation determines the total amount paid back on a mortgage loan over its lifetime. The interest rate on loan is substituted into the formula as a constant. Therefore, it is only applicable to fixed-rate mortgages since the interest rate on adjustable-rate mortgages fluctuates over time. This only works if the interest rate remains stable throughout the loan's duration.
Borrowers can check their ability to afford mortgage payments using the constant. However, it is also useful in other contexts. To some extent, it can help real estate investors decide whether or not a given property represents a sound financial investment. Likewise, it can aid mortgage lenders in figuring out whether or not a borrower has the means to pay back the loan.
Mortgage Constant Example: Band of Investment
Let's say we're trying to determine what cap rate would be suitable for valuing an Orlando, FL office building. To begin, we can contact several local lenders to inquire about the terms of loans for this type of property. We can use one of the earlier approaches to determine the mortgage constant if underwriting standards for office buildings today call for 75% loan-to-value, a 25-year amortization period, and an interest rate of 5%.
The resulting value for the annual mortgage constant is 0.07015. To do this, we take an average of both rates of return and assign equal weights to them, giving us an overall rate of return of 8.01%. You can calculate this by multiplying the mortgage constant by the LTV ratio and then adding the cash-on-cash return multiplied by one minus the LTV ratio: (7.015% x.75) + (11% x.25) = 8.01%.
Calculating the Mortgage Constant
An annualized sum of mortgage payments would be divided by the entire loan amount to derive the mortgage constant. With a 30-year fixed-rate mortgage for $300,000, your monthly payment would be $1,432. Use a mortgage calculator to see how rate changes affect your monthly payment.
- The annual cost of debt service is $17,184 (12 x $1,432), or $1718 per month.
- 5.7% (or $17,184/$300,000) is the constant rate of the mortgage.
The Shortcomings of the Loan Constant
However, commercial mortgages with adjustable or variable rates cannot use the loan constant since it is impossible to predict it given the ever-changing interest rates accurately. The same holds for interest-only (I/O) loans, which cannot use the loan constant.
What About Cap Rates?
In real estate investing, the cap rate is a widely used measure. Although the mortgage constant is sometimes referred to as the "mortgage capitalization rate," real estate investors use a different rate, the "cap rate," to gauge a property's profitability. The capitalization rate is calculated by dividing the property's net operating revenue by the total loan amount. This method is quite similar to the mortgage constant, except that it employs net operating income rather than interest payments.
The Relationship Between the Loan Constant and Cap Rate
A good indicator of whether or not a property will be profitable is to compare its loan constant to its cap rate. To put it another way, if the loan constant on a property is higher than the cap rate, the property will incur a loss. To illustrate how to determine a property's cap rate, let's use the same property from above and assume it generates $185,000 a year in net operating income.
- $2,000,000/$185,000 = 10.8%
Benefits and Risks of Using the Mortgage Constant
A mortgage constant is a useful tool for evaluating investments since it can be computed quickly and with little effort, and the data required is typically available. Also, the outcome may reveal helpful details regarding the deal's prospective profitability. The main problem with using a mortgage constant is that it is static. This means that the denominator (the loan amount) shifts every time principal and interest are repaid on the loan. Therefore, it is not sufficient for making a final investment call. Consider it one piece of information among many.
Conclusion
The annual payment or interest rate is expressed as a percentage of any particular loan's total amount, known as the mortgage constant. The annual financial outlay required to keep up with mortgage payments can be estimated using the mortgage constant. Lenders and investors in real estate use the mortgage constant to calculate if the borrower's income will cover the loan's yearly debt servicing obligations. It's the rate at which a mortgage is capitalized.
