Cost of debt is a figure that shows how much you’ll pay for borrowing funds. It can be calculated as either an annual pre-tax percentage or an annual after-tax figure by using your company’s tax rate.
- The pre-tax figure can be calculated by taking the sum of your annual interest payments and dividing that number by the total amount of loans you’ve taken out.
- The after-tax figure factors in tax savings and can be determined by subtracting your company’s tax rate from one, and then multiplying that by the pre-tax figure.
You can find these figures quickly by using our cost of debt calculator.
Cost of Debt Formula & Examples
Cost of debt can be calculated in one of two ways. First, it can be calculated without factoring in your company’s corporate tax rate, which is referred to as the pre-tax cost of debt figure. If you want to account for the corporate tax savings of your business, you calculate an after-tax cost of debt figure, both of which we discuss below.
Pre-tax Cost of Debt Formula & Example
The pre-tax cost of debt formula is shown below.
Pre-tax Cost of Debt = | Total Interest |
Total Debt |
Where:
- Total interest refers to the total annual interest charges you’ll pay.
- Total debt figure refers to the balances of the loans you’ve taken out.
Below is an example of how you could calculate the pre-tax cost of debt given several different types of loans and interest rates on each:
Annual Interest Calculation | |
|---|---|
Working capital loan ($50,000 at 10%) | $50,000 × 10% = $5,000 |
Business line of credit ($20,000 at 12%) | $20,000 × 12% = $2,400 |
Business term loan ($30,000 at 9%) | $30,000 × 9% = $2,700 |
Business credit card ($5,000 at 20%) | $5,000 × 20% = $1,000 |
Total Interest | $5,000 + $2,400 + $2,700 + $1,000 = $11,100 |
Pre-tax Cost of Debt Calculation | |
Total Annual Interest ÷ Total of Loan Balances | [$11,100 ÷ ($50,000 + $20,000 + $30,000 + $5,000)] × 100 = .1057 |
Pre-tax Cost of Debt As a Percentage | .1057 × 100 = 10.57% |
After-tax Cost of Debt Formula & Example
The after-tax cost of debt formula is shown below. To calculate it, you’ll need to know the before-tax figure from above and your company’s marginal corporate tax rate.
After-tax Cost of Debt | = | Pre-tax Cost of Debt × (1 − Marginal Corporate Tax Rate) | |
Marginal Corporate Tax Rate | = | 1 - | Net Income |
Total Debt | |||
To illustrate how these figures would be calculated, let’s take the same scenario as before and assume that it has generated $1 million of income before taxes.
Marginal Corporate Tax Rate Calculation | |
|---|---|
Pre-tax income | $1 million |
Net income after taxes | $800,000 |
Marginal Corporate Tax Rate | 1 − ($800,000 ÷ $1 million) = 0.20 |
After-tax Cost of Debt Calculation | |
Pre-tax Cost of Debt | .1057 (see above calculation for steps) |
After-tax Cost of Debt | .1057 × (1 − 0.20) = .08456 |
After-tax Cost of Debt as a Percentage | .08456 × 100 = 8.456% |
Why You Should Be Aware of Your Cost of Debt
As a business owner, getting access to capital is often a necessary part of being able to grow and expand the company. The cost of debt calculator is a tool that can help ensure you’re not paying too much for this additional funding and that you stay on the right track when it comes to managing your finances. This includes ensuring that you stay within your budget, that you avoid taking on loans you can’t afford, and that any expected returns on investments are sufficient to cover the costs of borrowing.
What Is a Good Cost of Debt Figure?
In general, a good cost of debt figure, whether pre-tax or after-tax, is under 10%. However, this can vary depending on your specific company’s circumstances.
For example, certain types of loans may carry higher-than-average interest rates, which may be acceptable if the expected return on investment is also higher. Similarly, businesses with a bad credit score may have to accept higher interest rates, which may also be acceptable if the alternative to not getting access to funding is less preferable.
Pros & Cons of Cost of Debt
| PROS | CONS |
|---|---|
| Can be used as an indicator of whether a company is paying too much for financing | Excludes other loan costs, such as origination fees, underwriting fees, and third-party expenses |
| Has results that can help determine the minimum rate of return needed to break even on an investment | Is used alone; is not a reliable indicator of a company’s ability or likelihood to qualify for additional financing |
| Can be used to help avoid risky or low-return investments | Provides a limited snapshot of a company’s overall financial health |
How to Reduce Your Cost of Debt
If you want to reduce your cost of debt, there are several methods by which you can accomplish this. This can include:
Shopping Lenders for Better Rates
We recommend getting quotes from multiple lenders to ensure you can get the best rate possible. In addition to obtaining quotes from different lenders, consider checking with multiple types of lenders—such as credit unions, banks, online lenders, and business loan brokers.
Different lenders may have varying policies, qualification requirements, and risk appetites that can make it easier for you to get approved for a lower rate. Similarly, lenders sometimes offer incentives for new borrowers or certain loan programs. Regardless of the type of loan you’re getting, shopping rates is a crucial step in getting a small business loan.
Considering Alternative Funding Sources
The less money you need to borrow, the fewer interest charges you’ll have to pay, and the lower your cost of debt will be. Similarly, less conventional sources of financing may allow you to pay fewer interest charges. Some examples include common startup funding sources such as borrowing money from friends and family, crowdfunding money, or completing a Rollover for Business Startups (ROBS).
Related Financial Ratios
Cost of debt is just one of several financial figures and ratios you and lenders may use in evaluating your financial health. Since it provides a limited snapshot of your company’s finances, we recommend using it in combination with multiple financial ratios. Some examples include your company’s debt service coverage ratio (DSCR), debt to income (DTI) ratio, and current ratio.
- DSCR is a measure of your company’s ability to pay debts from its cash flow. It’s calculated by taking your company’s net operating income and dividing it by its annual debt obligations. You can also use our DSCR calculator to see where you stand.
- DTI compares the amount of your company’s monthly debt payments against its monthly income. Lenders often use the gross income but may exclude certain types of debt in calculating your DTI. We have a DTI calculator that you can use.
- Current ratio is one measure of your company’s ability to cover liabilities due within one year with assets that can quickly be converted into cash. Due to the number of items that liabilities and assets can be categorized as, we recommend using our current ratio calculator to help you keep track of these items.
Frequently Asked Questions (FAQs)
Keeping track of your cost of debt can help prevent you from getting a loan you can’t afford. Even if you land a loan approval, lenders do not always take into account all forms of debt your company may be responsible for.
In most cases, yes. Lenders may not directly evaluate your cost of debt; however, companies with high cost of debt figures typically have greater debt obligations, which will be revealed when the lender evaluates other financial ratios, such as its DSCR or DTI figures.
A high cost of debt usually means a company is paying a high amount of interest charges relative to its loan balances. This can be indicative of a company with bad credit, little time in business, poor finances, or other circumstances that caused it to have to resort to high-interest debt.
Bottom Line
As a business owner, knowing what your cost of debt is can help keep your finances in order. It’s a measure of the amount of interest you’re paying relative to your loan balances. A high cost of debt may be an indicator that you’re paying too much to access additional capital. If this is the case, we recommend considering whether the return on your investments is large enough to justify the high cost of borrowing funds.
