While the commercial lending market comes with its fair share of risk, investors are able to evaluate certain factors, such as a loan constant, to help mitigate some level of uncertainty.
In this context, a loan constant is a percentage that represents how much a lender has received in interest and principal payments in contrast to the full sum of the mortgage.
The term is also referred to as a mortgage constant.
What Is a Loan Constant and How Does It Work?
A loan constant in commercial lending sets the annual debt service, the amount needed to pay off the principal and interest repayment over a pre-established time frame, against the value of the mortgage principal.
For both borrowers and investors alike, a loan’s contractual terms, like the mortgage interest rate, payment schedule, and total principal, are considered to determine a loan constant.
Borrowers tend to prefer a mortgage with a low loan constant since the percentage determines the amount they will have to pay in a year, including fixed interest.
Investors, however, use loan constants to gauge if a rental property, like an office, multifamily home, or retail space, is worth their time and resources before going through the underwriting process.
How Do You Calculate a Loan Constant?
Compute the loan constant with a simple formula that involves dividing the annual debt service by the entire amount of the loan principal:
Loan Constant = (Annual Debt Service) / (Loan Principal)
For example, if a first-time homebuyer takes out a 25-year mortgage for a residence at $200,000 with a fixed interest rate of 7%, they would have to pay $1,413.56 a month on their loan.
Keep in mind this calculated monthly payment amount also includes interest.
Multiply $1,413.56 by 12, the number of months in a year, to calculate the annual debt service, which ends up coming out to $16,962.72. Next, to find the loan constant of this homebuyer’s mortgage, divide the annual debt service ($16,962.72) by the complete loan amount ($200,000).
The homebuyer’s loan constant is 8.48%.
Are There Ways To Reduce a Loan Constant?
To possibly lower a loan constant, a borrower could consider negotiating with the lender or creditor regarding the interest rate or loan term before signing an agreement. However, if a borrower has already signed the contract for a loan, they could look into refinancing options.
Different lenders may give competitive quotes to match the lowest rate, which a borrower can use to leverage better offers. This is why shopping around when in the market for a loan is important. It takes time to shop around, but it can pay off big in the long run.
Taking steps to improve a loan application also potentially increases the likelihood of success when negotiating more favorable loan terms. Borrowers can attempt to increase their credit score and pay off some of their existing debt, whether from student loans or credit cards.
Borrowers who want to boost their chance for success can also put down a larger initial down payment to try and decrease the rates on their loan terms during the negotiation phase. If the loan runs at a higher rate, it’s always possible to renegotiate further down the line.
What Are Loan Constant Tables?
Before financial calculators became commonplace, loan constant tables let real estate professionals quickly and easily determine the monthly payments borrowers had to make on their mortgages.
The tables often consisted of a y-axis that indicated years, starting from one and increasing steadily by an integer and an x-axis that denoted interest rates.
By examining the number of years in relation to the interest rate on the table, the resulting value would correspond to the loan constant.
A loan constant table makes determining a mortgage constant simple by providing a straightforward and visual way to find the relevant percentage.
It meant no longer needing to write out numbers and mathematical formulas or manually entering numbers on a calculator. It became a huge timesaver that helped to reduce the potential for human error.
What Is the Difference Between a Loan Constant and Cap Rate?
In the commercial real estate industry, the anticipated rate of return on an investment property represents the capitalization rate, or cap rate. To calculate the cap rate, divide the property’s net operating income by the present-day value on the real estate market.
Simply put, investors use a cap rate to determine their potential yield or return on investment.
On the contrary, an investor or borrower can compute a loan constant by dividing the annual debt service by the mortgage principal. In addition, the percentage assists investors in deciding if a property is worth the investment rather than how much they expect to receive in returns like a cap rate.
Generally, when a cap rate is lower than a loan constant, there is a fair chance the property may not generate a profit. For example, take a mortgage on an industrial property with a loan constant of 5% and a cap rate of 4%.
In this case, there appears to be more debt service than income, meaning the outcome leads to negative leverage. These percentages for the loan constant and cap rate would suggest the investor may lose money on their real estate property.
Why Is a Loan Constant Important?
When an investor is considering a property, a loan constant gives partial insight into the total yearly costs, including annual debt service, involved in managing a loan or mortgage.
Plus, using a loan constant in comparison to a cap rate could provide a window into whether or not a property appears promising in terms of cash flow and return on investment.
A loan constant can simplify budgeting for borrowers by adding transparency to the monthly payment amounts and annual debt service. Additionally, modern financial calculating tools help borrowers understand how much they can afford to obtain and repay in a set amount of time.
By experimenting with different numbers on the financial calculator, the borrower could become empowered to negotiate terms like the interest rate or loan duration with the lender or creditor.
What Are the Benefits and Disadvantages of a Loan Constant?
A loan constant gives a borrower the advantage of knowing how much they will have to pay in a given year on a mortgage, with interest included in the total amount. This allows them to budget carefully to ensure they can afford the payments.
In general, a lower loan constant implies a borrower owes the creditor less money throughout the duration of the loan.
When it comes to investing, however, the percentage offers a relatively quick way to decide if a property is worth the time and resources it takes to manage a loan.
In addition, a loan constant is only one data point for investors to evaluate before they form an opinion on whether or not a property is worth the investment. The cap rate is another worthwhile component to consider for analysis of potential real estate.
Unpredictable factors, such as an unstable housing market where values for properties can fluctuate, may affect the current fair value of properties for rent or otherwise. Economic conditions could also influence property values with changing interest rates over time.
Even if a property loses value over time, investors could take advantage of tax deductions due to rental property depreciation.
Key Takeaways
- A loan constant determines the amount needed to pay off both principal and interest over a set time frame.
- Loan constants can be calculated with by dividing the loan principal by the annual debt service.
- Loan constants can only really be lowered by negotiating with the lender prior to taking out the loan, or by refinancing with a new lender at a lower rate.
- A lower loan constant means less money owed throughout the life of the loan.
Looking for more info on all things related to commercial real estate loans? Explore the Loanbase Learning Hub here.
