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.
Loan Constant Explained
A loan constant can be used for all types of loans. It helps borrowers and analysts to better understand the factors involved with a loan and how much they are paying annually in comparison to the loan principal.
Calculating Loan Constant
Calculating the loan constant often requires a borrower to obtain the multiple terms associated with a lending deal. Terms include factors such as total principal, loan interest rate, length of payments, and frequency of payments. Obtaining these loan term factors allows for a simple-present-value payments calculation 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
For example, take a mortgage borrower who has obtained a $150,000. The loan has a fixed interest rate of 6%, with a ten-year duration and monthly interest payments. Using a payments calculator, the borrower would calculate monthly payments of $1,665.31, which result in annual debt service of $19,983.72. With this annual debt service the borrower’s loan constant would be 13%, or $19,983.72 / $150,000.
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 13% 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 120.