A loan constant is a percentage that represents the annual debt service on a loan compared to its total principal value. It’s calculated by dividing the annual debt service by the total loan amount. When evaluating loans, borrowers can compare the loan constants of various options to determine which has the lowest debt service requirements. This means the borrower will pay less in interest and principal over a given period. It’s important to note that loan constants are only applicable to fixed interest rate loans, not loans with variable interest rates.
Key Takeaways
- A loan constant is a percentage showing the annual debt service of a loan compared to the total principal value.
- Factors like principal, loan interest rate, and the duration and frequency of payments are used to calculate a loan constant.
- Loan constant tables and calculators are popular tools for determining mortgage payments.
- Borrowers usually prefer loans with lower loan constants because they imply lower debt service payments.
How a Loan Constant Works
A loan constant compares a loan’s annual debt service to its total principal value. A loan’s debt service is the total cash the borrower must pay to cover the repayment of interest and principal for a given period. The loan constant, expressed as a percentage, can be determined for all types of loans and helps borrowers and analysts understand how much they are paying annually compared to the loan principal.
A mortgage constant is a specific type of loan constant related to real estate loans.
Calculating a Loan Constant
Calculating the loan constant requires obtaining multiple terms from the lender, such as total principal, loan interest rate, the length of payments, and the frequency of payments. Once you have these terms, calculate the monthly payments through a payment calculator to find the annual debt service. Finally, you can compute the loan constant with the following equation:
Loan Constant = Annual Debt Service / Total Loan Amount
For example, consider a borrower who obtained a $150,000 mortgage with a fixed interest rate of 6% for 30 years, and monthly payments of $899.33. The annual debt service equals $10,791.96. Thus, the loan constant for this loan is 7.2% ($10,791.96 / $150,000).
Special Considerations
When you multiply the loan constant by the original loan principal, you get the dollar amount for the annual periodic payments. The loan constant is used to compare the true cost of borrowing. Loan constants are only available for loans with fixed interest rates since variable rates result in varying annual debt service levels. Among comparable loans, borrowers generally opt for the one with the lower loan constant, indicating a lower debt service requirement.
Loan Constant Tables
Before the advent of financial calculators, loan constant tables were widely used to calculate monthly mortgage payments easily. These tables offer borrowers prepopulated information about their loan at a specific loan constant level.
If the borrower mentioned earlier referenced a loan constant table, they could find their terms without extra inputs. Identifying the 7.2% loan constant, they would locate the 6% interest rate on the horizontal axis and 360 months (the length of payments) on the vertical axis.
In commercial real estate, the loan constant’s relevance is highlighted when compared to the capitalization rate. This comparison can help investors determine profitability. For example, if an investor buys an apartment building with a 7% cap rate and their loan constant is 6%, they earn 1% on borrowed money and 7% on equity. Conversely, if the loan constant is 7.5%, the investor loses 0.5% on the mortgaged portion.
Related Terms: debt service, principal value, fixed interest rate, loan interest rate, mortgage.
