What Is a Mortgage Constant?
A mortgage constant is the percentage of money paid each year to pay or service a debt compared to the total value of the loan. The mortgage constant helps to determine how much cash is needed annually to service a mortgage loan. It's calculated as dividing the annual debt service for the loan by the total loan value.
- A mortgage constant is the percentage of money paid each year to pay or service a debt given the total value of the loan.
- The mortgage constant helps to determine how much cash is needed annually to service a mortgage loan.
- The mortgage constant is used by lenders and real estate investors to determine if there's enough income to cover the annual debt servicing costs for the loan.
Understanding a Mortgage Constant
A mortgage constant is the percentage of money paid to service debt on an annual basis divided by the total loan amount. The result is expressed as a percentage, meaning it provides the percentage of the total loan paid each year. The mortgage constant can help borrowers determine how much they'll pay each year for the mortgage. The borrower would want a lower mortgage constant since it would mean a lower annual debt servicing cost.
Real estate investors use a mortgage constant when taking out a mortgage to buy a property. The investor will want to be sure they charge enough rent to cover the annual debt servicing cost for the mortgage loan. Banks and commercial lenders use the mortgage constant as a debt-coverage ratio, meaning they use it to determine whether the borrower has enough income to cover the mortgage constant.
Calculating the Mortgage Constant
To calculate the mortgage constant, we would total the monthly payments for the mortgage for one year and divide the result by the total loan amount.
For example, a $300,000 mortgage has a monthly payment of $1,432 per month at a 4% annual fixed interest rate.
- The total annual debt servicing cost is $17,184 or (12 months * $1,432).
- The mortgage constant is 5.7% or ($17,184 / $300,000).
The mortgage constant only applies to fixed-rate mortgages since there's no way to predict the lifetime debt service of a variable-rate loan—although a constant could be calculated for any periods with a locked-in interest rate.
Applications of the Mortgage Constant
A mortgage constant is a useful tool for real estate investors because it can show whether the property will be a profitable investment. Meanwhile, debt yield is the opposite of the mortgage constant. Debt yield shows the percentage of annual income based on the mortgage loan amount. If the debt yield is higher than the mortgage constant, the cash flow is positive, making the investment profitable.
Using the earlier example, let's say an investor wanted to buy the house to rent it out. The monthly net operating income (NOI) received from the rental property is expected to be $1,600 per month. The net income is the monthly rent minus any monthly expenses. The loan amount to purchase the property was $300,000 from our earlier example.
- The annual net income is $19,200 or $1,600 x 12 months.
- The debt yield is calculated by taking the annual net operating income of $19,200 and dividing it by the loan amount of $300,000 to arrive at 6.4%.
- If you recall, the mortgage constant was 5.7%, and since the debt yield is higher than the constant, it would be a profitable investment.
In other words, the annual net income from the property is more than enough to cover the annual debt servicing costs or the mortgage constant. As stated earlier, banks or lenders can also use the mortgage constant to determine if a borrower has the annual income to cover the debt servicing costs for the loan.
The calculation would be done the same as above, but instead of using monthly rental income, the lender would substitute the borrower's monthly earnings. The bank would need to calculate the borrower's monthly net income or the cash left over after expenses and other monthly debt payments were paid. From there, the lender could calculate the annual net income and the debt yield to determine if it's enough to cover the mortgage constant.