When you borrow money, you must pay for the use of funds. Exactly how much is called your cost of debt.
There are a couple of different formulas you need to know to calculate your cost of debt. Find out what they mean and how to use them.
What Is Cost of Debt?
Cost of debt refers to the total interest your company pays if you finance your business with debt, such as a loan, mortgage, lease, bond or note. This cost is expressed as an interest rate.
When your cost of debt is added to your cost of equity, the result is your cost of capital. Your cost of capital represents the total cost you pay to raise capital funds for your business.
Your cost of debt can tell you how taking out a loan or pursuing an investor will affect your company’s finances. It also can help you determine whether the debt or equity opportunity makes sense for your business. Further, it can help potential lenders evaluate your ability to repay debt.
Cost of debt includes 2 major components: your interest rate and tax rate.
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Difference Between Cost of Debt and Cost of Equity
While cost of debt refers to the interest a company pays if it uses debt financing, cost of equity refers to the return a company pays out to its equity investors.
Cost of Debt Interest Rate
One thing you need to know to determine your cost of debt is the interest rate you pay on your debt.
Many lenders quote an annual percentage rate (APR). Although you can use APR when calculating your cost of debt, using your effective interest rate is a more accurate method.
Your effective annual interest rate considers the number of times the debt is compounded during the year and the costs associated with that.
Tax Rate
Since interest on business loans can be tax-deductible, cost of debt is normally calculated after taxes are factored in. As a result, you also need to know your tax rate to calculate your cost of debt.
This tax-rate figure represents your total rate between federal, state and local tax rates. Your results will differ depending on whether you use your effective tax rate or marginal tax rate.
Effective Tax Rate vs. Marginal Tax Rate
Your effective tax rate is the total federal income tax you pay as a percentage of your total income.
For example, if you earned $1 million last year and paid $100,000 in federal income tax, your effective tax rate was 10%.
Your marginal tax rate is the rate applied to the last dollar of your income.
If you earned $1 million, your marginal tax rate is 37%. However, you don’t pay that percentage in taxes on your entire income. You only pay that rate for the amount of money you earn over that tax bracket’s minimum, while the first dollar earned will be taxed at the rate for the lowest tax bracket and all the money in between is taxed at the rate for the range into which it falls. In 2022, for example, you’d pay 37% in taxes for income exceeding $539,900 ($647,850 if you’re married filing jointly).
How to Calculate Cost of Debt
You can use several different formulas to figure out how to find your cost of debt in a spreadsheet or with a cost of debt calculator. In its simplest form, you could calculate cost of debt by dividing total interest by total debt.
Alternatively, the most common formula is the after-tax cost of debt calculation.
After-Tax Cost of Debt Formula
The after-tax cost of debt formula calculates cost of debt by multiplying your effective interest rate by 1 minus your effective tax rate:
After-Tax Cost of Debt = Average Interest Expense x (1 – Tax Rate)
The average interest rate is calculated by taking all of the interest paid for the year and dividing it by the total debt.
To illustrate how the formula works, let’s assume your average interest rate for the year was 6% and tax rate is 35%. Converting percentages to decimals, your after-tax cost of debt would be as follows:
After-Tax Cost of Debt = 0.06 X (1 – 0.35) = 3.9%
Alternatively, you may consider using a cost of debt calculator, such as Schwab’s Moneywise tool.
What Can Affect the Cost of Debt?
Several factors can increase or decrease the cost of debt, such as the following:
Lower cost of debt:
- Lower interest rates
- Loans secured by collateral typically have a lower cost of debt
Higher cost of debt:
- Unsecured loans
- Loans with longer repayment periods
- Loans to riskier borrowers
Why Your Cost of Debt Matters
Knowing your cost of debt provides the critical information you need to make a smart decision about a loan or another financing opportunity. It also helps you and potential investors evaluate the financial state of your business.
Additionally, having this information can improve your financial planning and ability to attract financing.
Calculate your cost of debt to get a complete view of your cost of capital and a firmer foundation for making strategic financing decisions.
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Cost of Debt Financing Key Takeaways
- Cost of debt is the overall interest rate your company has to pay on borrowed money.
- Because interest on business loans is tax-deductible, tax rates are often included in debt cost calculations.
- Cost of debt is a major part of your company’s overall cost of capital, which varies based on how much of your capital is debt and how much is equity.
- You can calculate the cost of debt using a simple formula. A financial calculator can also help.
How to Improve Your Cost of Debt
There are several ways you can lower your company’s overall cost of debt:
- Replace unsecured loans with secured loans
- Pay off balances on business credit cards and other high-interest financing accounts
- Have investors inject equity capital that can be used to pay down debt
- Refinance short-term debts with long-term loans
