Loan Constant Definition and Explanation
Loan constant is a percentage which compares the entire amount of a loan by its annual debt service. Learn more in our commercial mortgage quick reference guide.
A loan constant, also known as a mortgage constant, is a percentage which compares the entire amount of a loan by its annual debt service. In addition to DSCR, LTV, and debt yield, a loan constant is an important metric that lenders use to determine a property’s suitability for a commercial or multifamily loan. A loan constant can also be thought of the as a kind of cap rate for lenders. In order to determine a property's loan constant, a borrower will need to know information including the term, interest rate, and amortization of a loan. In general, loans with lower loan constants are generally more profitable for borrowers.
Loan Constant Formula
The formula to determine a loan constant is:
Mortgage Constant = Annual Debt Service ÷ Loan Amount
For instance, a 20-year, fully amortizing loan of $2,000,000 with a 5% interest rate would incur $158,389 in payments each year, with a loan constant of 7.9%.
$158,389 ÷ $2,000,000 = 7.9%
If you only have the mortgage constant and the principal loan payment, you can multiply the mortgage constant by the principal in order to determine the monthly payment on the loan:
$2,000,000 x 7.9% = $158,000 (rounded)
The Shortcomings of the Loan Constant
While the loan constant is a valuable metric, it cannot be applied to adjustable or variable rate commercial mortgages, since the constant change in interest rates makes it impossible to determine an accurate loan constant. For similar reasons, the loan constant cannot effectively be applied to interest-only (I/O) loans.
The Relationship Between the Loan Constant and Cap Rate
Comparing a property’s loan constant with its cap rate is one of the best ways to determine whether it will be profitable. A property with a loan constant that exceeds its cap rate will lose money, will a property with a cap rate higher than its loan constant will lose money. For example, if we take the property in the example above, and say that it’s generating $185,000 a year in net operating income, we would calculate it’s cap rate like so:
$2,000,000 ÷ $185,000 = 10.8%
Since, in this case, the cap rate is higher than the loan constant, the property would be profitable.
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