I was reading a number of forums in the last few days about some amazing deals that fellow investors were finding. Some of them were even putting up numbers and asking if they were missing anything in their analysis. And I thought nothing of it but I was putting together some long responses to help people out to improve their deal analysis. And then I had a thought. This is something that very few people seem to know about. So here it is… The financial advantage in knowing what a loan constant is.
So what is a loan constant?
A loan constant, sometimes referred to as a mortgage constant, is the factor by which banks determine how much money they will make off of a loan. Essentially the capitalization rate of a loan for the bank. Or to put it bluntly, the factor that tells you how much money that loan will cost you. Investopedia has a longer but more detailed definition:
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.
But let me be clear here, the loan constant is not the same thing as the interest rate. The loan constant is based on the interest rate as well as the length of the loan and the terms, fully amortizing or interest only. The key in the definition above is the last sentence “used to compare the true cost of borrowing.”
So how is the loan constant calculated?
Great question! There are two ways that I’ve come across. The first is the equation method, for those of us math nerds out there, presented below:
Loan Constant = [ i / 12 ] / ( 1 – ( 1 / ( 1 + [ i / 12 ] ) ^ n ) ) * 12
i = the APR interest rate of the loan (%)
n = the number of months in the term of the loan
There is also a simpler method, still using math, that needs the monthly principal and interest payment and the original loan balance.
Again, to be blunt. Everyone. You may not know it, but your whole financial world revolves around loan constants. It is a not-so-widely-discussed aspect of the financial industry. We personally didn’t even know that such a term existed until we had been learning about private lending and investing for nearly a year. Why would this key aspect of the financial industry not be widely known? Because this is how the banks make some of their money and they don’t want the common consumer to figure it out. (But that is for another discussion).
Here is an example. You want to buy a house for $100,000, you’ve been listening to friends and family and the radio and tv about where to get the best rates for a loan. You make some calls and get some “indicative rates,” because no mortgage broker (salesman) will give you actual rates until you commit and get a credit check. Even then you have to “act fast to lock in your rate” because it could change at a moment’s notice. You put together the following table, with your new found knowledge about loan constants.
By now you’ve heard a number of different pieces of advice:
You want the shortest loan term so that you can pay your loan off faster and be debt free!
Get the lowest interest rate!
Banks are crooks!
So let’s take a look at this advice.
The shortest term you found was ten years, loan 3! Wow thats fast and you could have the house paid off and be debt free! But the loan constant is 13.63%. Wow, that seems pretty high, so let’s look at the other loans.
Loans 1 and 4 have a 15 year term, which is good and still short term, and have a better interest than the 10 year loan. Loan 4 has a much lower loan constant! We must be on the right track now! Who could beat a 4.0% interest rate? Well you keep going through the analysis, even though your are thinking that you’ve found your loan.
Then you look at loan 2, 30 year loan at 4.25% and has a loan constant of 5.9%! So now you’re thinking “wait whats going on here?” But then you heard this one offer of an interest only loan at 6% and thought, no way that would be what I want, but the loan constant is only 6%! Essentially the same as the 4.25% loan.
What does this mean in terms of dollars and cents? So you add the following rows to your table and compare.
15 years & 5% interest rate
30 years & 4.25% interest rate
10 years & 6.5% interest rate
15 years & 4% interest rate
30 years & 6% interest rate
Total Interest Paid Over Life of Loan
Interest Cost per Year
Total Principal & Interest Annual Cost
Loans 2 and 5, which have the lowest loan constants have the lowest monthly payment and the lowest total annual payments. But the loan with the lowest total interest paid over the life of the loan is the loan with the lowest interest rate, loan 4. So this is where answers to questions start to become “it depends.” Which loan is best? Depends on your goals for your cash flow, investment returns, opportunity costs, personal preferences, etc.
Let’s look more closely at loan 4. It has the lowest interest rate of the five loans and has the lowest annual interest cost. This means that over the life of the loan you will be paying the lowest possible amount of interest. This is directly related to the interest rate. BUT. And there’s always a but. That low total interest paid is a direct result of paying $247.75 more every month. More cash out of your pocket that you could be using to live on. So the question here is whether or not you can live on $247.75 less every month, or $2,973 per year, to feel good about paying off your loan faster?
Now let’s look at loan 2. It has the lowest loan constant of the five loans, and besides the interest-only loan, it has the lowest loan constant by a long shot. This loan also has the lowest monthly payment of all the loans, but you pay for it over 30 years rather than a shorter 15 years. When we also looked at the total annual interest cost, where we are only $360.35 higher than loan 4 discussed above, the question now is are you ok with a longer loan, ultimately paying more interest, but having more cash in your pocket now?
A final parting thought on this discussion. How long have you lived in your current residence? How long would you plant to live in this house you are considering buying? The National Home Builders Association states (most in recently 2013) that the average American family will live in their home for just over 13 years. So, assuming you have a 15 year mortgage, is coming to within two years of being “debt free” worth paying the extra $38,649 in interest ($2,973 x 13 years)? Only you know that answer for you.
So why do I need to know this?
Our mentor always asks us “So, what’s the cost of not knowing this?” His answer is usually 5, 6 or even 7 figures over the course of a working lifetime. The above example was 5 figures in 13 years! What could be done with an extra $2,973 per year in your pocket? The opportunity cost of that money is astronomical over the course of 10, 15 or 30 years of a mortgage. Having this kind of knowledge in your tool box is a game changer. Being able to understand what you are getting yourself into on a mortgage, one of the biggest debts for the average American, is key to your financial future.
All of the crazy loans that were going on in the 2000’s with crazy interest rates, adjustable rate mortgages, low and no money down loans and all the rest. All of these things contributing to the increased loan constant of the loan. I won’t go through the numbers, but just imagine that you have a 5 or 7 year adjustable rate mortgage that was so popular back before the bubble burst. You have an astronomically high loan constant, even with a low interest rate, that then changes up before you can get a better loan. Further driving the borrower down and hobbling their ability to improve their financial situation.
Let me give you a quick real world example of how this comes into play. Stephanie and I are going through a 1031 Exchange on a rental property. We are turning one high appreciating rental into six high cash flowing rentals. One into six. When we started looking at numbers we knew what we needed as far as our metrics and cash flows to make the properties perform well, but we also knew that you make your money when you buy, and that means having excellent financing. So when we talked to the banks, we knew what range of terms and interest rates were acceptable to us. That’s right! We were screening banks to give us what we wanted, not what they wanted to give us. This shifts the whole power dynamic of the transaction. I spoke with three bankers about this deal, one in person. I showed them the entire analysis and walked them through the metric choices and details of each property as well as the portfolio. You know what I got back? Glazed over looks and deer in headlights. They didn’t know anything about what I was talking about. I knew more than my bankers did about their own product!
So why do you need to know this? You need to know this for your financial well being. Your ability to get the right loan for the right asset. You need to know this to keep from digging a deeper financial hole for yourself and your family that you may never be able to get out of. As the saying goes “when you’re in a hole, stop digging.” This same process works for anything that you are borrowing money for, not just for houses with mortgages.
Please, please, please, read this. Reread it. Think about it. Talk about it with your spouse, your friend, your sibling or a perfect stranger. Write comments and ask questions. This is far too important to not understand and put into your everyday understanding of your financial landscape.
I hadn’t intended for this to get so long, but I feel that I need to make sure I provide a complete picture and give enough information to understand. Please let me know if this is helpful or if it’s too much to take in. I want to make sure that I’m providing significant value to you.