The mortgage constant explained

If you’re thinking of becoming a real estate investor, or already own a few rental properties, you probably want to understand exactly how much of a return on your investment you’re earning.  That means you’ll want to track your mortgage amortization.  The mortgage constant helps answer these questions by telling you whether your debt service costs are too high.

Let’s take a look at what a mortgage constant is, how it works and the formula for calculating it.

What is a mortgage constant, and how does it work?

A loan constant tells you how much of a fixed-rate loan is being paid off each year over the course of the term. There’s no such constant with variable- or adjustable-rate loans because the payment is recalculated over the remainder of the term each time the rate adjusts. The change means the borrower isn’t paying off a consistent amount each year.

Simply put, a mortgage constant is a specific type of loan constant which looks at how much debt is paid off per year on fixed-rate mortgage loans.

Mortgage constants vs. other real estate metrics

Mortgage constants are important because they’re one way of evaluating whether something is a good investment, for all sides of the transaction. Mortgage lenders and the loan investors who help fund their loans want to know how much they’re being paid back each year. Home buyers, real estate investors and homeowners want to know this when evaluating their loan options.

Debt yields vs. mortgage constants

Real estate investors can also use this with other metrics such as net operating income to help them determine whether a rental is profitable based on the loan terms they’re being offered. If the rate of return they’re getting each year compared to the loan amount (also referred to as debt yield) is higher than the mortgage constant, the investment is profitable.

Cap rates vs. mortgage constants

Capitalization rates are another way to determine how well a real estate investment works. To get your cap rate, you take your net operating income for the year and divide by the market value of the property. It gets a little more complicated because investors have to consider not only how much they’re charging for rent, but also the vacancy factor and taxes.

Later on, we’ll take a look at how you can use both of these metrics in concert to see whether something is a good investment based on returns.

How to determine your home loan constant

To calculate your home loan constant, you’ll need to know your total loan amount and monthly payment.

You can use our mortgage calculator to help you figure out your monthly principal and interest payment, if you don’t know it already.

The mortgage constant formula

There are a couple of ways to calculate the mortgage constant, including using an online calculator or spreadsheet software. However there is a simple formula you can use to calculate it yourself.

If you know your monthly principal and interest payment and total loan amount, you can use the formula:

(Principal + Interest)  ?  12  ?  Loan Amount

The top part of this equation is referred to as your annual debt service. This is the total amount it would take to completely erase your loan debt.

One thing to keep in mind here is that the mortgage constant works a little bit differently than your amortization schedule. The constant is a fixed percentage that doesn’t change. However, if you look at your amortization schedule, at the beginning of the loan you pay more toward interest and then you pay more toward the principal later on.

Calculating the mortgage constant: An example

Now that we know the variables, let’s run through an example of calculating the mortgage constant. Let’s say you have a $300,000 loan amount for a 30-year fixed loan at 3.5% interest.

Once you determine your monthly principal and interest payment from a mortgage calculator, you can plug in your numbers. The formula comes out to the following:

(1347.13  ?  12)  ?  300,000

This comes out to about 5.389%. Keep in mind, you should only be including your principal and interest payment and not your taxes and insurance.

How to use your mortgage constant: An example

Let’s say you have an annual income of $36,000 from a property that’s worth $300,000 with the same 30-year mortgage. Your cap rate is 12%.

Now let’s assume you wanted to know whether it was a good investment, and you want to compare it to your mortgage constant to determine your profit. When you subtract the mortgage constant from earlier, you’re still making a 6% annual return on the investment.

Obviously, the higher the return, the better the investment is, but this is another way of looking at profitability.

Mortgage constants and residential vs. commercial mortgages

Whether you’re new to real estate investment or a couple of steps ahead and already managing some properties, you should know that you can have up to 10 residential mortgages for single family homes. Also, a “single-family home” is defined by the government as any home with up to four units. So, you could own up to 40 units without going through the commercial real estate loan process.

Regardless of which type of loan you are using to finance your real estate investment, metrics like the mortgage constant will help you evaluate the impact of financing costs on your profitability.

Mortgage constant FAQs

Let’s take a look at a few commonly asked questions about the mortgage constant and its uses.

Why is the mortgage constant higher than the interest rate?

Since the mortgage constant takes both the loan’s principal and interest into consideration, it will always be higher than the interest rate on any amortized loan. The interest rate only factors in interest and not the loan’s principal.

Why is the mortgage constant important?

The mortgage constant is important because it helps determine the profitability and return on investment of your real estate purchase. A lower constant usually means higher profitability for all involved in the transaction.

Should the cap rate or mortgage constant be higher?

In general, the mortgage constant for a loan should be lower than the cap rate. When the cap rate is lower than the mortgage constant, the investment is likely to be unprofitable.

The bottom line: Mortgage constants help you understand your debt service costs

Mortgage constants help you understand whether you are paying too much for debt service, and if debt service is cutting into your profitability. Real estate investors use mortgage constant, debt yield, cap rate and other real estate metrics to understand their costs and maximize their profits.

Ready to buy a rental property? Take action and start your mortgage application with the Home Loan Experts at Rocket Mortgage^®.