A loan constant is the amount of cash paid to the lender in relation to the outstanding loan balance. You calculate your loan constant by figuring out how much principal and interest is paid to the lender annually and dividing that by the total loan amount.
Many borrowers look for a loan constant that’s as low as possible because it means you’ll pay less money toward the loan each year. Learning how to figure out your loan constant will make it easier to compare your lending options in the future.
Definition and Examples of a Loan Constant
The loan constant, sometimes referred to as a mortgage constant, calculates the total debt service in relation to the outstanding balance on a loan. It considers both the interest and the principal paid on an amortizing loan.
- Alternate definition: A loan constant is the amount of interest and principal paid to a lender compared with the total loan amount.
- Alternate name: Mortgage constant
Figuring out your loan constant helps you determine what you’ll pay annually for that loan. Investors often look at the loan constant to determine whether a property is worth investing in.
A lower loan constant means the property will be more profitable to a potential investor.
How a Loan Constant Works
Borrowers can use loan constant tables and calculators to figure out the total cash they’ll have to pay annually to cover the interest and principal on a loan. You can figure out your loan constant using the following equation:
Loan constant = Annual debt service / Loan balance
However, a loan constant is only helpful if you have a fixed-rate loan or mortgage. If you take out a loan with a variable interest rate, there’s no way to correctly calculate the annual debt service.
For example, let’s say a borrower is considering buying a property that costs $300,000. The interest rate is 5% amortized over 30 years.
Using a debt-service coverage calculator, we can determine that the annual debt service is $19,326. When you divide that number by $300,000, you get a loan constant of 6.4%.
But what if the same loan was amortized over 25 years? In that case, your total debt service would be $21,045, and the constant is 7%.
- A loan constant is the amount of principal and interest paid to the lender in relation to the total loan amount.
- Most borrowers look for a lower loan constant because it means they owe their lender less money annually and for the life of the loan.
- Before financial calculators became widely available, most borrowers used a loan-constant table to determine what their monthly payments would be.
- Investors often compare the loan constant against the cap rate to determine whether a property is a good investment.
Before financial calculators became widely available, most borrowers would use loan-constant tables. These tables made it possible to calculate the annual loan payments without using a calculator. These tables contained information about their loan, including the total loan amount, interest rate, and loan terms. This would help borrowers figure out what their monthly payments would be.
Loan Constant vs. Cap Rate
|Loan Constant||Cap Rate|
|Loan constant = Annual debt service / Loan||Cap rate = Annual net operating income / Cost|
|Helps borrowers determine the total interest and principal paid annually on a loan||Helps investors determine the total yield on an investment|
The loan constant is one way investors can determine whether a certain property is likely to be profitable, based on the cost of the loan. And once they’ve determined the loan constant, investors will usually compare that number with the capitalization rate or “cap rate.” The cap rate is calculated using the following formula:
Cap rate = Annual net operating income / Total cost
If the loan constant is higher than the cap rate, that property is likely to lose money. If the two numbers are equal, the investor will break even. And a loan constant that’s lower than the cap rate is a profitable investment.