Loan Constant
A loan constant is the annual debt service on a loan expressed as a percentage of the loan principal. It shows how much a borrower pays each year (principal + interest) relative to the original loan amount. Loan constants apply to fixed-rate loans and are commonly used to compare borrowing costs and to evaluate real estate investments.
How it works
- Annual debt service: total cash paid during a year to cover principal and interest.
- Loan constant = Annual debt service / Total loan amount.
- A lower loan constant means lower annual payments relative to the loan principal.
- The term “mortgage constant” is used when the loan is a real estate mortgage.
Calculation
- Determine the periodic payment (typically monthly) using the loan terms: principal, fixed interest rate, payment frequency, and number of payments.
- Monthly payment formula (for reference):
PMT = r * PV / (1 − (1 + r)^−n)
where r = monthly interest rate, PV = loan principal, n = total number of monthly payments. - Multiply the periodic payment by the number of payments per year to get annual debt service.
- Divide annual debt service by the original loan amount to get the loan constant.
Formula:
Loan Constant = Annual Debt Service / Total Loan Amount
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Example:
– Loan: $150,000, fixed interest 6%, 30 years, monthly payments.
– Monthly payment ≈ $899.33 → Annual debt service = $899.33 × 12 = $10,791.96.
– Loan constant = $10,791.96 / $150,000 ≈ 0.072 ≈ 7.2%.
Uses and interpretation
- Comparing loans: Borrowers often choose the loan with the lowest loan constant because it implies lower annual cash requirements.
- Mortgage analysis: Lenders and borrowers use the mortgage constant to compare financing options for real estate.
- Commercial real estate: Compare the loan constant to the property’s capitalization rate (cap rate). If cap rate > loan constant, the financed portion is producing a positive spread; if cap rate < loan constant, the financed portion may lose money.
- Example: 7% cap rate vs. 6% loan constant → 1% positive spread on borrowed funds.
Limitations and considerations
- Only valid for fixed-rate loans; variable-rate loans change annually and have no single constant.
- Does not account for up-front fees, closing costs, taxes, insurance, or changes in payment amounts over time.
- Useful as a straightforward cash-flow metric but should be used alongside other measures (APR, total cost, cash-on-cash return) when evaluating loans or investments.
Key takeaways
- The loan constant quantifies annual debt service as a percentage of the loan principal.
- It helps compare the annual cash burden of fixed-rate loans and assess the financing portion of real estate investments.
- Choose the loan with the lower loan constant for lower annual debt service, but consider fees and other costs before deciding.