Need Help? Give us a call.
1 (800) 345-3452
Before you commit to a business loan, you should know what the debt you’ll be taking on will help your business accomplish. Whether you want to launch a new product, open another storefront, or hire a new employee, the loan has to help your business grow and increase your company’s profits. Otherwise, the loan simply isn’t worth the cost.
This is what makes cost of debt such an important concept. By calculating cost of debt, you can figure out not only the true cost of a specific loan but also whether you can justify taking on that debt given your business’s goals. In other words, cost of debt gets you thinking about how a loan will impact your overall business strategy. And that’s something that every small business owner should understand before signing a loan agreement.
Of course, you’ll need to think about many other things, too—the interest rate, the frequency and size of payments, the length of time to repay the lender, and how quickly you’ll get the funds—but understanding cost of debt will help you know whether to pull the trigger.
Find out the formula for cost of debt, see how to use the formula with a few examples, and learn how to lower your borrowing costs and become a smarter borrower.
Cost of debt is the total amount of interest that a company pays over the full term of a loan. The cost of debt accounts for tax deductions that the company can claim on interest expenses. Business owners can use cost of debt to evaluate how a loan can increase profits.
Determining the cost of debt is important when you’re shopping around for a business loan. You might have heard of the saying, “You can’t make an omelet without breaking some eggs.” This is often true for small businesses.
In order to move the needle, business owners often need to rely on debt financing. But there comes a tipping point where there’s too much debt and not enough growth. Cost of debt helps you identify this tipping point.
When you calculate the cost of debt, you can compare that to the income growth that will come from the capital. For instance, if you can use a $10,000 low-interest-rate loan to create a new product that’ll land your business hundreds of new clients, 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.
Prospective lenders might also evaluate your cost of debt by looking at projections in your business plan. If your cost of debt is too high, the lender might not approve you for the loan, unless you can propose a different use of funds with higher growth potential.
→TL;DR (Too Long; Didn’t Read): Cost of debt tells you the total interest expense of a business loan, accounting for tax deductions. You can then evaluate the loan by comparing the cost of debt to the business income the debt will generate.
Lenders, investors, and business owners calculate cost of debt in different ways, but the most common formula is this:
Seems like a simple enough formula, but things can get complicated quickly, says Brian Cairns, CEO of Cairns Consulting LLC. The formula can be 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 details,” Cairns says, “are important when it comes to taxes, interest rates, and cash flow.”
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 tax rate. But don’t just rely on last year’s tax returns for an estimate because recent tax reforms might put you in a new tax bracket.
They key here is that you have to 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. 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 your, or use a business loan calculator.
Once you have the total interest cost and your average tax rate, you’re finally ready to use the formula to calculate cost of debt! Let’s start with a simple example to see how the formula works.
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 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, Cairns says, you can now compare the cost of debt to the net income that the loan will generate. “If the income potential is greater than the cost of debt,” he explains, “then the loan is a positive investment. If not, the loan is not a favorable 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.
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 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 (which shows more detail than a calculator):
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, the cost of debt 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.
Heads up: 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.
→TL;DR: The formula for cost of debt is Interest Expense (1 – Tax Rate). To begin, calculate your average tax rate, accounting for federal, state, and local taxes. Then, calculate your total interest expense using a business loan calculator or amortization schedule before plugging the numbers into the formula.
See the Loan Options You Qualify For
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:
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.
Here are some tips to lower your interest rate:
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 cost of debt would go down to $4,964 (instead of $6,232). And for larger loans, the impact of small rate changes is even higher.
Another way to lower your cost of debt is to refinance your business loan. You might initially start out with a business loan that has a very high interest rate because you can’t qualify for anything else. But you might be able to refinance your business loan with a lower-rate loan after several months.
In the interim, work on increasing your credit score and building up your business revenue. Eventually, you’ll be able to qualify for a better loan that you can use to pay off the first loan. Refinancing won’t lower your cost of debt right away, but is a long-term strategy. Depending on your specific situation, you can refinance with the same lender that gave you the original loan or with a new lender that offers better rates.
Matthew Nicolosi, who works closely with lenders and borrowers at Fundera, says:
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 multiyear term loan or an SBA loan. Business owners can restructure their installments or lower their overall interest rate.”
Cost of debt is ultimately about making a comparison. You can’t look at the result in a vacuum. 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, 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.
You might be able to generate more income by increasing profit margins on your product, entering more lucrative markets, or taking other steps. For example, a $0.50 increase in the price of your goods might yield thousands more dollars of income for your business, and justify taking on a loan.
→TL;DR: The best way to decrease cost of debt is to find a loan with a lower interest rate or to refinance later. Also make sure that you’re leveraging all opportunities to increase your business’s income.
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.
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 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, and the Harvard Business Review has a great explanation.
→TL;DR: Cost of capital, APR, and cost of debt are all related to the cost of borrowing money, but they are different. APR is the effective cost of a loan for one year. Cost of debt is the cost of a loan over the full term. Cost of capital is the total cost of equity and debt financing.
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:
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!