What Is a Loan Constant?
A loan constant is a percentage that shows the annual debt service on a loan compared to its total principal value. The calculation for a loan constant is the annual debt service divided by the total loan amount. When shopping for a loan, borrowers can compare the loan constant of various loans before making a decision. The loan with the lowest loan constant will have lower debt service requirements, meaning the borrower will pay less in interest and principal over a given period. Loan constants are only applicable to fixed interest rate loans and not loans with variable interest rates.
Key Takeaways
- A loan constant is a percentage that shows the annual debt service of a loan compared to the total principal value of a loan.
- Principal, loan interest rate, and the length and frequency of payments are used for calculating a loan constant.
- Loan constant tables and calculators are popular for calculating mortgage payments.
- When shopping around for a loan, borrowers will often opt for the loan with the lowest loan constant as this means the debt service payments for that loan will be lower.
How a Loan Constant Works
A loan constant is a comparison of a loan’s annual debt service to the loan’s total principal value. A loan’s debt service is the total cash the borrower must pay to cover the repayment of interest and principal on the loan for a given period.
The loan constant is expressed as a percentage and can be determined for all types of loans. It helps borrowers and analysts to understand better the factors involved with a loan and how much they are paying annually in comparison to the loan principal.
Calculating a Loan Constant
Calculating the loan constant often requires a borrower to obtain from the lender the multiple terms associated with the lending deal. Terms include factors such as total principal, loan interest ratelength of payments, and frequency of payments. Obtaining these loan term factors allows for the calculation of a simple present-value payment to arrive at the monthly payments. Once the monthly payments are identified, a borrower can easily calculate their loan constant using the following equation:
Loan Constant = Annual Debt Service / Total Loan Amount
For example, take a mortgage borrower who has obtained a $150,000 loan. The loan has a fixed interest rate of 6% with a 30-year duration and monthly interest payments. Using a payments calculator, the borrower would calculate monthly payments of $899.33, which results in an annual debt service of $10,791.96. With this annual debt service, the borrower’s loan constant would be 7.2% or $10,791.96 / $150,000.
Special Considerations
The loan constant, when multiplied by the original loan principal, gives the dollar amount of the annual periodic payments. The loan constant can be used to compare the true cost of borrowing. Loan constants are only available for loans with fixed interest rates since variable interest rates have differing annual debt service levels based on variable interest. Given the choice of two loans, a borrower will generally opt for the one with the lower loan constant, since it will have the lower debt service requirement.
Loan Constant Tables
Loan constant tables were widely used in the real estate industry before the advent of financial calculators since they made it relatively easy to calculate monthly mortgage payments. Loan constant tables provide prepopulated information for borrowers about their loan with a quoted loan constant level.
If the borrower from the example above were given their loan constant, they could find the interest and payment terms from a loan constant table without other inputs. The borrower would only need to identify 7.2% in the table. From there, they would find the corresponding interest rate of 6% on the horizontal axis. On the vertical axis, the number of payments in months would also be provided at 360.
The concept of loan constant is especially relevant In the area of commercial real estate, since when compared to the capitalization rate, an investor can tell if they will actually make or lose money on the part of the investment they finance. For example, if an investor is buying an apartment building with a 7% cap rate and their loan constant is 6%, then they will be earning 1% on the borrowed money and 7% on equity. However if the loan constant is 7 1/2%, then the investor would be losing 1/2 of 1% on the mortgaged part of the investment.