Investors talk about rate. Lenders size loans off something else. The loan constant is the bridge between the two, and it is probably the most useful number in rental finance that almost nobody outside a credit department uses by name.
It answers three questions at once. How much debt will this property carry. Does borrowing make my return better or worse. And what happens to both of those answers when the rate moves. Once you can compute it in your head you stop guessing at loan sizing, because loan sizing is just this number turned upside down.
The definition
The loan constant, sometimes called the mortgage constant, is annual debt service divided by the original loan amount, expressed as a percentage.
That is the whole thing. Take the payment, multiply by twelve, divide by the loan.
A 180,000 dollar loan at 7.25 percent on a thirty year amortization has a payment of 1,227.91 a month. Twelve payments is 14,735 dollars a year. Divide by 180,000.
The loan constant is 8.186 percent.
Notice that it is higher than the interest rate, and notice why. The rate only covers interest. The constant covers interest plus the principal you are forced to repay on schedule. That forced repayment is real money leaving your account every month, and the constant is the only common metric that counts it.
This is exactly why comparing two loans on rate alone is misleading. Rate is one input to the constant. Term is the other, and on a shorter amortization the term does more work than the rate does.
How term and rate each move it
Hold the rate at 7.25 percent and change nothing but the amortization:
- Interest only: constant of 7.250 percent
- Thirty year: constant of 8.186 percent
- Twenty five year: constant of 8.674 percent
- Twenty year: constant of 9.484 percent
Now hold the amortization at thirty years and move the rate:
- 6.75 percent: constant of 7.783 percent
- 7.25 percent: constant of 8.186 percent
- 7.75 percent: constant of 8.597 percent
- 8.25 percent: constant of 9.015 percent
Look at the two lists side by side. Going from a thirty year to a twenty year amortization at the same rate raises the constant by 1.30 points. Getting hit with a full point of rate on the same thirty year term raises it by 0.83. Ten years of amortization cost you more than a hundred basis points of rate.
That is a genuinely counterintuitive result and it explains a lot of otherwise confusing lender behavior. It is also why the interest only option is such a powerful lever on coverage, and why the number jumps the moment the interest only period ends. Interest only against amortizing is a decision about your loan constant whether or not anyone uses the phrase.
Turning the constant into a loan amount
Here is where it becomes a working tool rather than trivia.
Coverage is net operating income divided by annual debt service. Annual debt service is the loan amount times the constant. So:
Maximum loan = net operating income divided by (target coverage ratio times the loan constant).
Take a property with 15,000 dollars of net operating income, built the way a lender will actually accept it. Target a 1.20 coverage ratio. Use the 7.25 percent thirty year constant of 8.186 percent.
15,000 divided by (1.20 times 0.08186) equals 15,000 divided by 0.098232.
Maximum loan is roughly 152,700 dollars.
That is the debt-service constrained loan amount. It has nothing to do with the appraised value. The property might support far more debt on a loan to value basis and it does not matter, because the smaller of the two constraints governs. On lower yielding properties the coverage constraint is almost always the binding one, which is why investors are so often surprised that a property appraising at 300,000 will only carry 152,700.
Now change one input and watch the proceeds move.
- Rate rises to 8.25 percent, thirty year. Constant 9.015 percent. Maximum loan drops to 138,700. A single point of rate cost you about fourteen thousand dollars of proceeds, or 9.2 percent of the loan.
- Same 7.25 percent rate, twenty five year amortization. Constant 8.674 percent. Maximum loan drops to 144,100.
- Same 7.25 percent rate, interest only. Constant 7.250 percent. Maximum loan rises to 172,400. Nearly twenty thousand dollars more, at the identical rate.
Nothing about the property changed in any of those scenarios. The rent is the same, the expenses are the same, the appraisal is the same. Only the constant moved. You can run these permutations yourself on the DSCR deal calculator, and the coverage ratio walk through covers what belongs in each half before you start.
The positive leverage test
This is the best use of the loan constant and the reason it deserves a place in your working vocabulary.
Compare the property’s cap rate to the loan constant.
- Cap rate above the constant: positive leverage. Each borrowed dollar earns more in the property than it costs to service, so adding debt raises your cash-on-cash return.
- Cap rate below the constant: negative leverage. Each borrowed dollar costs more than it earns, so adding debt lowers your cash-on-cash return.
- Cap rate equal to the constant: neutral. Leverage changes the size of the bet without changing the return.
Run it on a real property. A duplex bought at 240,000 dollars producing 15,071 of net operating income has a cap rate of 6.28 percent. The thirty year loan at 7.25 percent has a constant of 8.186 percent.
6.28 percent against 8.186 percent. That is negative leverage, and by nearly two full points.
Watch what it does. All cash, the property returns its 6.28 percent. Put 180,000 of debt on it at that constant and annual debt service is 14,735, leaving 336 dollars of cash flow against roughly 60,000 dollars of equity. That is a cash-on-cash return of about 0.6 percent.
Leverage took a 6.3 percent return and turned it into a 0.6 percent return. The loan is not defective. The rate is market. The property simply does not yield enough to feed it, and the constant is the number that told you so before you closed.
This is the honest version of a conversation that usually happens in vaguer terms. Investors talk about whether the numbers work. The loan constant makes it a one line test. It also explains why the same investor can be right to use maximum leverage on an eight cap and wrong to use any leverage at all on a five cap, and why cap rate and coverage ratio measure different things despite both being built from net operating income.
It also puts a floor under return expectations. If you know your constant, you know the cap rate you need to buy at for leverage to help you. At an 8.186 percent constant, anything under an 8.2 cap is a deal you are buying for appreciation or for the amortization, not for current return, which is precisely the fork described in the cash flow versus appreciation trade-off.
Where amortization complicates the picture
There is a fair objection to the negative leverage verdict above, and it is worth taking seriously.
The loan constant counts principal repayment as a cost. But principal repayment is not really a cost. It is a transfer from your checking account to your equity. In year one of that 180,000 dollar loan at 7.25 percent, roughly 1,860 dollars of the 14,735 paid is principal. That money did not disappear. It bought equity.
So the strict cash-on-cash return is 0.6 percent and the return including principal paydown is closer to 3.7 percent. Both figures are true and they answer different questions. If you need the property to pay you now, use the cash number. If you are building equity over a ten year hold, principal paydown counts and the picture improves considerably. Cash-on-cash return is deliberately narrow for this reason, and it is worth knowing which version of return you are quoting when you quote one.
What the constant is unambiguously right about is liquidity. Principal repayment may be equity, but it is equity you cannot spend, and the payment is due whether or not the property had a good month. Negative leverage on paper becomes negative cash in practice the first time a unit turns.
A few practical uses
Compare loan offers on the constant, not the rate. A quote at 7.00 percent on a twenty five year amortization carries a constant of 8.463 percent. A quote at 7.375 percent on thirty years carries 8.494 percent. Those two loans are within three basis points of each other in real cost, and the one with the higher rate is very slightly cheaper on a cash basis. Rate alone would have told you the opposite.
Size the deal before you shop it. If you know the property’s net operating income and you know roughly where constants are sitting, you can calculate your own maximum proceeds in thirty seconds and find out whether the acquisition is even financeable at the price under discussion.
Stress test the constant, not the rate. When you model what a refinance looks like in three years, the question is not what the rate will be, it is what the constant will be, because the amortization you are offered at that point matters as much as the pricing. Programs that give you a fresh interest only period land in a completely different place than programs that put you on a twenty year schedule.
Understand what you are paying for on short term debt. On construction and rehab financing the concept shifts, because you are paying on drawn balances rather than a fixed amortizing loan. The equivalent question there is what you are charged on money you have not yet used, which is the whole substance of dutch versus non-dutch interest. Same instinct, different instrument.
Sanity check it against the simpler metrics. The constant tells you what debt costs. The gross rent multiplier tells you what you paid. The operating expense ratio tells you what the building consumes. Three numbers, three different failure modes, and a deal has to survive all three.
The short version
Annual debt service divided by the loan amount. That is the constant. It is always higher than your rate, it moves more on amortization than on pricing, and it converts directly into a maximum loan amount when you divide net operating income by the constant times your target coverage.
Compare it to your cap rate before you decide how much to borrow. Above the constant, leverage is your friend. Below it, every additional dollar of debt is making your return worse while making your risk higher, and no amount of enthusiasm about the property changes that arithmetic.
We are a Pittsburgh-based brokerage and we finance investment properties for investors across Pennsylvania and additional states. If you want the constant run on two or three structures side by side before you pick one, send the scenario through our contact page or call 412-990-2941.
FMC Capital, NMLS #1840537. This article is general information for real estate investors and is not a commitment to lend or an offer of specific terms. Rates, amortization options, coverage thresholds, and program guidelines vary by lender, property, and borrower and are subject to change. All figures shown are illustrative.
Licensed mortgage broker, NMLS #1840537. Loan products and qualification standards vary and are subject to change without notice.