Why Loan Constants Matter

The last time you financed something, your loan constant analysis should have directed you to the most advantageous financing. If you have no idea what I am talking about, then you need to understand the concept and calculation of a loan constant.   When comparing financing options, most look strictly at interest rate as the deciding factor, while that is an important item, the life of your business and its cashflow is more important.  Use the loan constant to determine which loan has the lowest impact on your capital.

According to Investopedia, a loan constant is: “An interest factor used to calculate the debt service of a loan. The loan constant, when multiplied by the original loan principal, gives the dollar amount of the periodic payment. The loan constant can be used to compare the true cost of borrowing. Given the choice of two or more loans, a borrower will generally opt for the one with the lower loan constant, since it will have the lower debt service requirement.”

When financing investment property, the loan constant must be lower than the cap rate for the property to cash flow. Many people look at the cap rate and say if the interest rate is lower than the cap rate a property will cash flow (this is not always true).

The quoted interest rate of a loan is strictly the amount of interest that loan accrues. The loan constant, on the other hand, is expressed as an interest rate that incorporates both the interest and principal repayment of a loan. The formula is:

Loan Constant = [Interest Rate / 12] / (1 - (1 / (1 + [interest rate / 12]) ^ n))

n = the number of months in the loan term

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