The Loan Constant – An Old “New” Way of Looking at Debt
Business owners and individuals are always asking “how do we deal with outstanding debt,” particularly when they have too much. A common way to approach this problem is to look at the interest rate charged on the loan. That might make intuitive sense at first but it doesn’t help much when creating a solid plan to pay down debt. If we were only dealing with interest rates on the debt and not required to make principal payments, comparing loans would only involve the interest rate charged. In the real world, most debt involves principal and interest payments over time.
For those not familiar with these terms, principal payments are the portion of your monthly payment applied to what you actually borrowed, rather than the interest you’ve accrued. You can sometimes see these broken out, depending on the lender you’re using, like the example below.
So how do principal payments change the analysis of your debt? Principal payments, generally, make up the majority of your monthly required payment. “Required portion” is the key here. You can’t just pay the interest if you don’t have enough money to pay the full amount. In fact, the minimum interest and minimal principal payment combine to create the required monthly payment – neither portion is optional.
Every loan has different terms to, eventually, pay back the principal. We call this the “loan payment structure.” One loan might have a high interest rate but be, overall, less expensive than another loan with a low interest rate because of the required principal payment or terms to pay back the principal payment. In other words, one loan payment structure could incorporate a higher interest rate but take much less time to pay back, resulting in less overall interest. However you look at it, the interest rate is not the only thing to look at when determining what to pay back.
So how do we determine what to pay off first? By using an important – and long-standing – concept for debt management called the “loan constant”. The loan constant for any loan is calculated very easily:
- Take the required minimum monthly payment and multiplying that amount by 12
- Take the result and divide it by the current outstanding loan balance
- Sort your loans by loan constant
The higher the loan constant the, more harmful that loan is for you. If you wanted to pay off loan balances and did not know which ones to pay first, calculating the loan constant will answer that question. Simply start paying off the highest loan constant value loans first, working your way down the list. Have a tie? Now use the interest rate to make your decision between the two.
As an example, let’s take a credit card with a 12% interest rate and a car loan with an 6% rate. Before we compare the interest rates, let’s calculate the loan constants. Our credit card is making us pay $25 per month on a balance of $2000, giving us a loan constant of 0.15. Our car loan requires us to pay $450 on a balance of $10,000, giving us a loan constant of 0.54. Despite its smaller interest rate, the car loan is the first one we should concentrate on.
Let’s take the loan constant one more step further to be very precise in our choices and management of debt. For a business, mortgage, or student loans, the interest portion of the debt is tax deductible. In order to complete this analysis, you need to look at the impact of the taxable portion of the principal portion of the debt.
The interest portion is deductible, which works to lower the interest cost. The principal portion, however, is taxable, which, in effect, increases the principal amount due. For the times where the interest portion is not tax deductible, the entire amount – interest and principal – paid with after tax funds. This increases the loan constant!
If you add the tax-affected payment portions together, multiply that result by 12, and divide by the current outstanding balance, the result will be a fully tax-affected loan constant. This, now, is the absolute best way to compare one loan to another.
Remember that the lower the loan constant, the better the loan is from a financial point of view!