Cost of Debt: Why It's Important and How to Calculate It

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To calculate pre-tax cost of debt, take the sum total of debt-related interest payments divided by the total amount of debt taken on for the year. To calculate post-tax cost of debt, subtract your business' marginal tax rate from 100% and multiply that to your pre-tax cost of debt.

Why your business' cost of debt matters

Cost of debt is an important metric for both internal and external reference. Internally, it's a useful way to see how much of an impact external finance has on your business. It's easy to lose track of exactly how much you're leveraging loans, bonds and other means to grow your business.

Say you calculate the cost of debt for an incoming loan to be $50,000. Let's also say that you plan on using the loan to fund inventory, which you project to result in $30,000 revenue. Since your cost of debt is much higher than the predicted growth, you can confidently determine that the loan isn't worth it.

Externally, it's a widely used metric that many lenders and partners use to determine your business' overall financial health. It's extremely relevant in the world of small-business lending, since lenders reference your cost of debt to assess if your business is too risky to lend to.

Pre-tax cost of debt explained

The pre-tax cost of debt is also sometimes referenced as the effective interest rate. It's not widely used, since the effective interest paid is tax deductible. To make calculating this as simple as possible, let's use an example.

Loan SizeInterest Rate
$500,000 loan4% interest rate
$250,000 loan6% interest rate
$200,000 loan5% interest rate
$50,000 loan6% interest rate

Interest payments for the loans are $20,000, $15,000, $10,000 and $3,000, respectively, which totals out to $48,000. Total debt equals $1,000,000.

Pre-tax cost of debt = (total interest payments) / (total outstanding debt) = $48,000 / $1,000,000 = 0.048 or 4.8%.

This formula may be an oversimplification, as a business' debt can change significantly throughout the year. However, it's a useful projection tool if you're trying to get a general sense of the cost of debt or if your business' debt doesn't vary much throughout the year.

Post-tax cost of debt

The post-tax cost of debt is more widely used than the pre-tax cost of debt because the pre-tax cost of debt or effective interest payments are tax deductible, since they qualify as business expenses.

Let's continue with the previous example and say sample business pays a federal rate of 35% and a state tax rate of 10%. The marginal tax rate is the sum of the two and equals 45%.

Post-tax cost of debt = (1 - marginal tax rate) x pre-tax cost of debt = (1 - .45) x 4.8% = 2.64%

How to improve your cost of debt

You should always calculate the cost of debt before committing to a loan or any other debt financing. The easiest time to lower the cost of debt for a given loan is before you actually borrow it.

1.) Shop around

Many businesses make the mistake of only applying for a single loan or financing from one lender. It makes sense, as the business loan application process often takes a long time and a lot of paperwork. However, shopping around for quality financing is the easiest way to ensure that you're at least starting with the cheapest rates available.

We'd recommend borrowers start their loan process with SnapCap, since it matches you with multiple lenders with just a single application.

SnapCap
SnapCap

2.) Negotiate better terms

When you qualify for a loan, you should have some room to negotiate for better rates. One common way to do this is to agree to a shorter repayment term in exchange for lower rates. It'll make the loan a bit harder to pay off, as your principal payments will likely be larger, but your interest rate will decrease.

3.) Refinance

Refinancing an active debt obligation will largely depend on your payment history. Lenders will usually be more open to refinancing if you've been making your payments on time or early. Another option is to shop around and refinance existing loans with other lenders.

FAQ

What's a good cost of debt?

There's no standard answer for this, but it should always be less than the benefit or gain you hope to achieve with your loan.

How do you calculate the cost of debt?

Pre-tax cost of debt = (total interest payments) / (total outstanding debt)

Post-tax cost of debt = (1 - marginal tax rate) x pre-tax cost of debt

What is considered debt?

Debt is any financial obligation owed to another organization. When calculating the cost of debt, it most often comes in the form of a loan.

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