Put the understanding of Loan Constant to work for you
Information from Rocket Mortgage.
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 are earning.
If you’re financing these property purchases, one of the big questions you might be looking to answer is whether your debt service costs are too high. The mortgage constant helps answer that question. If you’re a homeowner who looks at your home as an investment, you’ll want to track your mortgage amortization.
Before we get into the details, let’s discuss what a mortgage constant is.
What Is A Mortgage Constant, And How Does It Work?
A loan constant tells you how much of the 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 there’s no consistent amount being paid off each year.
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: What’s The Difference?
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 not only consider how much they are charging for rent, but also the vacancy factor and taxes.
In the next section, 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 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.
How To Determine Your Home Loan Constant
In order to calculate your home loan constant, you’ll need to know your monthly payment.
Use our mortgage calculator to help you figure out your monthly principal and interest payment.
The Mortgage Constant Formula
There are a couple of ways to calculate the mortgage constant. Let’s first go over a formula where you only need the mortgage rate and the loan term.
Mortgage Rate ∕ [ 1 − [ 1 ∕ (1 + Mortgage Rate) ✕ Mortgage Term in Months]]
There are a couple of variables here, so let’s touch on them.
- Interest rate: Because the interest rate associated with your mortgage is quoted annually, in order to get the amount of interest you pay monthly, you’re going to divide by 12.
- Mortgage term: Because the formula is based on monthly interest, you also need to quote your mortgage term in months, so you’re going to multiply your term by 12.
If you know what your monthly payment is, it’s a much easier formula to calculate the mortgage constant. All you need is your principal and interest payment and your loan amount. The formula is as follows.
(Principal + Interest) ✕ 12
______________________
Loan Amount
The numerator in that equation is referred to as your annual debt service. 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
Now that we know the variables, let’s run through an example of calculating the mortgage constant both ways. Let’s say you have a $300,000 loan amount for a 30-year fixed loan at 3.5% interest.
Let’s take the formula that only relies on the interest rate and mortgage term first. You would plug in the numbers like this:
(.035 ∕ 12) ∕ [ 1 − [ 1 ∕ (1 + ( (.035 ∕ 12) ✕ 360) ]]
This is much easier if you have some talent with Excel formulas. However, take our word for it that it comes out to about 5.389%.
If you use the second formula by getting a monthly principal and interest payment from a mortgage calculator, it comes out to the following:
(1347.13 ✕ 12) ∕ 300,000
That also comes out to about 5.389%. It’s also much easier to put into a calculator. The only word of caution with this one is that you should only be including your principal and interest payment and not your taxes and insurance.
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.
The Bottom Line: Mortgage Constants Help You Understand If Your Debt Service Costs Are Too High
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.
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You can get a copy of the Loan Constant Chart by clicking here.
