What Is Cost of Debt?
Cost of debt is the total amount of interest that a company pays over the full term of a loan or other form of debt. Since companies can deduct the interest paid on business debt, this is typically calculated as after-tax cost of debt. Business owners can use this number to evaluate how a loan can increase profits. Prospective lenders may also evaluate your cost of debt when deciding whether to approve your loan application.
The health of your business finances depends in large part on the cost of capital that your business takes on. By calculating cost of debt, you can figure out not only the true cost of a specific business loan but also whether you can justify taking on that debt given your business’s goals.
For instance, if you can use a $10,000 low-interest-rate loan to create a new product that’ll generate three times as much revenue, then the loan is probably worth the cost. But if the income potential of the loan doesn’t surpass the cost, you’re better off getting another loan or adapting your expectations.
In this guide, we’ll show you how to calculate cost of debt, including some examples, so you can apply the formula to your own business.
How to Calculate Cost of Debt
Lenders, investors, and business owners calculate cost of debt in different ways, but the most common cost of debt formula is:
Cost of Debt = Interest Expense (1 – Tax Rate)
Seems like a simple enough formula, but it can get confusing because different lenders quote interest expense in different ways, and businesses have different tax rates depending on their location and how they’re structured.
The first step is to find out your business’s average income tax rate, which you’ll plug in for “tax rate” in the formula. You can either ask your accountant for this or use a tax schedule to predict your business tax rate. Keep in mind that you must account for federal, state, and local taxes. To do so, divide your total tax liability by your total taxable business income. This will give you your business’s average income tax rate.
The second step is to get the total interest cost of the loan, which you’ll plug in for “interest expense” in the formula. The total interest cost should include any loan fees that are tax deductible (because you’ll be adjusting for taxes in the formula). Finding out total interest cost can be difficult because some lenders quote an annual percentage rate (APR), but others quote a factor rate or the total payback amount. Ask the lender to break down the total interest cost for you, or use a business loan calculator. APR is the most accurate interest rate because it also includes fees.
Once you have the total interest cost and your average tax rate, you’re finally ready to use the cost of debt formula. Let’s start with a simple example to see how the formula works.
Cost of Debt Examples
Here are a couple of examples that will help you understand how to calculate cost of debt.
Cost of Debt: Simple Example
Let’s say a friend gives you a $100,000 loan at an interest rate of 15%, and your business has a 25% average tax rate. For simplicity’s sake, let’s assume that the interest is applied up front to the principal (i.e. no compounding or amortization).
The cost of debt would be calculated as follows:
Cost of Debt = 15,000 (1 – .25) = 15,000 – 3,750 = $11,250
In this example, the cost of debt over the life of the loan is $11,250. With this number in hand, you can now compare the cost of debt to the net income that the loan will generate. If the debt will end up producing growth that’s more valuable than the cost, then the loan is a good business investment.
For instance, say the loan in our example will pay for an advertising campaign that you estimate will generate $50,000 in business income. In this case, the loan is definitely worth the cost. But if that campaign will only generate $10,000 in income, best not to take the loan—at least at the current interest rate and terms. In that case, you should continue shopping around for a more affordable business loan.
Cost of Debt: Complex Example
In the first example, we assumed that the lender charges all of the interest to the loan at the outset. But in reality, many business loans are term loans or long-term installment loans. Such loans amortize, which means that your principal and interest payments vary over the life of the loan. At the beginning of the term, the bulk of your payment goes toward interest. Later payments go mainly toward principal.
To calculate the cost of debt on an amortizing loan, you’ll need to add up the interest expenses associated with each payment. The sum of the interest expenses is what you plug in for “interest expense” in the formula. The easiest way to get this sum is with a business term loan calculator or amortization schedule.
For example, let’s take the same $100,000 loan and 15% annual interest rate, but let’s suppose that the loan has a five-year term with monthly payments. Plugging in these numbers into a calculator or amortization schedule shows that the total interest cost is $8,309.97.
Here’s how to get total interest cost from an amortization schedule:
Sample Amortization Schedule to Calculate Cost of Debt
|Month||Principal balance (start)||Payment||Principal||Interest||Principal balance (end)|
The cost of debt will now be lower than the earlier calculation:
Cost of Debt = 8,309.97 (1 – .25) = 8,309.97 – 2,077.49 = $6,232
As you can see, it is now lower because the principal balance decreases before the lender calculates the interest payment each month. In order for the loan to make sense now, the loan should generate more than $6,232 in net income in one year.
To be super accurate, you should add on any non-tax deductible fees (such as loan application fees, appraisal fees, and credit check fees) to the final cost calculation, rather than include those fees as part of the interest expense in the formula. This is because you’re multiplying interest expense by tax rate and don’t want to skew your result by initially including non-tax deductible fees. Knowing which fees are tax deductible can be tricky, so we recommend consulting a tax professional.
Parag Patel, a certified tax attorney, says:
The deductibility of the various expenses related to a business loan is commonly misunderstood. Points and other loan origination fees … are generally not deductible business expenses. That said, the term ‘points’ is often generally used to describe certain charges paid by a borrower to obtain a loan. These charges are also called loan origination fees, maximum loan charges, discount points, or premium charges. If any of these charges (or points) are solely for the use of money, they are [deductible] interest.
If, on the other hand, the charge is for a service that the lender is doing for you (e.g. packaging your loan), the fee isn’t deductible.
How to Lower Your Cost of Debt
You’ll want to do this cost of debt analysis on every business loan you plan to take. That way, you can focus on exactly what you plan to do with the money and how the loan is going to improve your business’s bottom line.
If you find that your cost of debt is too high, there are a few ways to remedy that:
1. Find Ways to Get a Lower Interest Rate
The most obvious way to decrease your cost of debt is by getting a lower interest rate. The stronger you are as a borrower, the lower your interest rate will be. Tips to lower your interest rate include:
- Take actionable steps to improve your credit score.
- Offer to put down business or personal assets as collateral.
- Get additional guarantors to sign for your business loan.
- Negotiate a decrease in interest rate with the lender after a certain number of on-time payments.
Remember, even small changes in your interest rate can have a significant impact on your cost of debt. In the example above, for instance, if the loan had a 12% interest rate (instead of 15%), the total would go down to $4,964 (instead of $6,232). And for larger loans, the impact of small rate changes is even higher.
2. Refinance Your Loan
If you can only qualify for a high interest rate when you first obtain your loan, you might be able to refinance your business loan with a lower-rate loan after increasing your credit score and business revenue. Refinancing won’t lower your cost of debt right away but is a long-term strategy.
As Fundera’s Matthew Nicolosi explains:
Refinancing can occur with the same lender or a different lender when a business owner has proven to be a responsible borrower with consistent and timely payments. Usually, as a business grows in revenue, becomes profitable, improves credit, or simply keeps operating for a longer time, the merchant becomes eligible to explore cheaper loan products.
“These events,” adds Nicolosi, “make merchants more credible in the eyes of lenders and permits business owners to graduate into cheaper options like a multi-year term loan or an SBA loan. Business owners can restructure their installments or lower their overall interest rate.”
3. Maximize Your Business’s Growth Potential
Cost of debt is ultimately about making a comparison. You have to compare the loan’s cost to the income the loan can generate for your business.
By increasing your business’s income potential—say, by increasing profit margins on your product or entering more lucrative markets—you can afford to take on more expensive debt. In other words, a 20% interest rate might be too high if you can only generate $10,000 in income, but the rate might be reasonable if you can generate $15,000 in income.
4. Shorten Your Repayment Term
If you have the cash flow, you can lower your cost of debt by taking out a loan with a shorter repayment term. For example, say you say take out a $100,000 five-year term loan with a 12% interest rate. Your monthly payment will be $2,224.44, and your cost of debt will be $33,466.69. Compare that to a $100,000 10-year term loan with an 8% interest rate. On the longer-term loan, your monthly payment will only be $1,213.28, but your cost of debt will wind up being $45,593.11 because you are making those interest payments over a much longer period of time.
Cost of Debt vs. APR
APR—annual percentage rate—expresses how much a loan will cost the borrower over the course of one year. APR takes the interest rate, fees, and any charges by the lender into account. In contrast, cost of debt measures the total interest expenses of a loan over the lifetime of the loan.
As mentioned earlier, a loan could have a high APR but a low cost of debt. For instance, it’s likely that a six-month short-term loan will have a high APR. Short-term lenders tend to work with borrowers who have less-than-perfect credit or need funding fast, so they charge high interest rates. Since the lender is charging a high interest over a short period of time, the APR is much higher relative to a long-term bank loan or SBA loan.
But that same six-month loan will have a low cost of debt since you’re paying off the loan relatively quickly. You won’t pay much in total interest over the life of the loan, so the cost of debt will be low.
You’ll want to use APR when loan shopping to compare the cost of different borrowing options. You’ll want to use cost of debt to analyze whether the loan will improve your business’s profitability.
Cost of Debt and Cost of Capital
Cost of capital is a company’s cost of equity and cost of debt, added together and weighted according to the percentage of debt and equity that the owner uses to run the business. If you’re using a combination of debt and equity financing to grow your business, you should understand how to calculate your total cost of capital. There are more formulas you’ll have to learn to do this, but the principle remains the same–will your business’s growth offset the cost of debt and equity financing?
The Bottom Line
Cost of debt is a very valuable metric when deciding whether a business loan is worthwhile for your business.
Here are some things to keep in mind when calculating cost of debt:
- The formula is Interest Expense (1 – Tax Rate).
- To get your tax rate, divide your total tax burden, accounting for federal and local taxes, by your business’s total taxable income.
- You can get the interest expense using an amortization schedule or business loan calculator.
- Once you know your cost of debt, you can compare the result to the income growth you believe the loan will help create.
Remember, if a loan can’t help your business grow and get to the next level, then the loan isn’t worth your money, time, and effort. But a loan can be a great investment if the capital will improve your business’s bottom line!
The post Cost of Debt: What It Is, Calculation, and Examples appeared first on Fundera Ledger.