Before your company takes on debt, it’s essential to know how much it’ll cost to borrow, otherwise your company may end up in a precarious financial situation.

In this article, we’ll explain how you can find the after-tax and before-tax cost of debt, the factors that determine the cost of debt, and how to reduce the overall cost of debt.

Key Takeaways:

• To determine the annual cost of debt, multiply your outstanding debt by its interest rate. The figure you get is the cost of debt before taxes.
• To find the after-tax cost of debt, multiply your interest rate by the result of one minus your effective tax rate, and then multiply this figure by the amount of debt you have.

How to Calculate the Cost of Debt

After-Tax Cost of Debt

To calculate the after-tax cost of debt (ATCD), you’ll need to use the equation:

(RFRR + CS) x (1 – Tax Rate) = ATCD

Risk-free rate of return (RFRR) is the theoretical rate of return for no-risk assets. Usually, the interest rate on a three-month U.S. Treasury bill (T-bill) is used for the RFRR part of the equation.

The difference in yield between a three-month T-bill and a debt security that’s different in quality but the same in maturity is known as a credit spread (CS).

Fluctuations in the economy are taken into account with this formula, and this is one of the main reasons why it’s so useful. Additionally, the amount of debt a company has, as well as its credit rating, are also taken into account. Basically, if a company has a lot of debt or a low credit rating, its credit spread will be higher.

For example, if the risk-free rate of return is 4%, and your company’s credit spread is 4%, its pretax cost of debt is 8%. Now, let’s say your company’s effective tax rate is 30%. If we input these values in the formula above, we arrive at an after-tax cost of debt of 5.6%.

Federal, state, and local tax codes usually treat interest paid on debt favorably, meaning borrowers can reduce what they owe in taxes if they make interest payments. Essentially, the after-tax cost of debt is the total amount you pay in interest minus any income tax savings from deductible interest expenses.

Let’s say your company issues $200,000 in bonds at 5%. This means you’ll have to pay out $10,000 in interest annually to your bondholders. Your company can then deduct $10,000 from its income, meaning it’ll save $3,000 with an effective tax rate of 30%. Therefore, you’re really only paying $7,000, or 3.5% interest, on the debt.

Pre-tax Cost of Debt

To calculate the before-tax cost of debt, you need to determine how much interest your company paid on all its debt throughout the year. Again, you’ll need to know the risk-free-rate of return, as well as your company’s credit spread.

Once you know how much your company paid in interest, divide this figure by the total amount of debt you have; this calculation will give you the average interest your company paid on all its debt.

For example, say your company has a $1 million loan at 6% interest, a $500,000 loan at 5%, and a $300,000 loan at 4%. You’d pay $60,000 in interest on the first loan, $25,000 on the second loan, and $12,000 on the third loan, totaling $97,000. Divide this figure by $1,800,000 to get ~5.38%—the average interest rate paid on your debt.

Now, if your company’s effective tax rate is 30%, your after-tax cost of debt would be ~3.76%.

What Factors Affect the Cost of Debt?

Creditworthiness

Your business’ creditworthiness is one of the most important factors that determines the cost of debt.

Basically, if you have very good (740-799) or excellent (800+) credit, it shouldn’t cost you a significant amount to borrow. On the other hand, if your credit is poor, you’ll probably be saddled with a higher interest rate that’ll substantially raise the total cost of borrowing.

This is how it is no matter which lender you choose. However, if you have very good credit, and you get a loan from a traditional lender, like a bank or credit union, there’s a good chance your interest rate will be on the lower side. But if you get a loan from the SBA, because your credit is bad, expect a higher interest rate and stricter loan terms.

Business Finances

The state of your business’ finances also plays a role in determining the cost of debt. If your company generates a lot of revenue and profit, lenders will be more willing to extend you credit with a low interest rate and favorable borrowing terms. Conversely, shaky financials will make borrowing more expensive.

When you submit an application for a loan or a line of credit, make sure you send in profit-and-loss statements, balance sheets, revenue statements, tax returns, and other relevant financial documents. These documents will allow the lender to get a clear picture of your business’ financial health and help you get advantageous loan terms.

Cost of Credit

The price of credit goes up and down in accordance with the state of the market. Essentially, when inflation starts to pick up, the Federal Reserve often raises the federal funds rate to get inflation under control.

This makes borrowing more expensive because interest rates go up across the board. When this occurs, lenders are more selective with who they extend credit to. And if you do get approved for a loan when interest rates are relatively high, you likely won’t get the best terms.

Lenders generally like periods of higher interest because they make more on their loans. However, when rates are high, borrowers are more at risk of defaulting, and a wave of defaults could spell disaster for big and small lenders alike.

How to Reduce the Cost of Debt

Renegotiate With Your Lender

If you’ve taken on debt and you’ve been meeting all your obligations for several months or a few years, your lender may be willing to renegotiate the terms of your loan agreement. For example, they may lower the interest rate so you don’t pay as much in the long run. Also, they could shorten the term to accomplish the same end.

However, if you pay back a loan too early, you’ll probably be forced to pay a prepayment penalty that amounts to 1-5% of the loan’s value. But if the penalty is less than what you’d pay in interest over the lifetime of the loan, paying the loan back early may be worth it.

Refinance

If your lender doesn’t want to renegotiate, you could refinance your outstanding debt. This can be accomplished in a number of ways. For one, you could take out a loan from another lender to pay off the original loan’s balance. Of course, this is only a good move if you can get better terms on the second loan.

Has your credit score improved because you’ve consistently made repayments on your original loan on time? Then you should be able to get better terms when you apply for another loan. However, choosing the right lender is essential here, as some won’t be willing to give you a good deal if they know your goal is to refinance.

Pay More Each Billing Cycle

To make debt cheaper, you can pay more each billing cycle. For example, some borrowers pay the minimum required plus the interest they expect to ensure the loan is always going down. Still, you may pay a lot in interest before you’re debt-free, but you’d probably save hundreds, if not thousands of dollars by doing this.

Borrow When Rates Are Low

You may not be able to, but if you can you won’t regret doing so. When rates are low, the overall cost of borrowing is much cheaper. But once rates start going up, even a 0.25 basis point increase of the federal funds rate can make borrowing much more expensive.

Why It’s Important to Know the Cost of Debt

Before your company issues bonds or takes out a loan, you need to understand how much the debt you’re taking on will cost. For loans specifically, you must know how much interest will tack on to the principal over the lifetime of the loan, how long it’ll take to pay off the loan, and the size and frequency of repayments.

If your business takes out a loan that it won’t be able to afford later on, it’s likely you’ll be forced to default, which will cause your collateral to be seized and sold, sink your business and personal credit scores, and subject your business to financial hardship.

When a lender approves your business for a loan, they’ll propose a loan agreement, wherein you’ll find the proposed interest rate, the term, and other important factors.

It’s essential that you calculate the cost of debt annually, as well as the total cost, before you agree to the terms. Never sign a loan agreement without knowing how much the debt will cost beforehand, as you may not be able to change the terms later on.

Also, taking on a substantial amount of debt will subject your business to high interest payments, and these may prevent your business from growing or operating efficiently.

Finally, don’t forget that interest payments are tax-deductible. If you deduct them from your annual income, you’ll lower the total cost of borrowing.

Final Thoughts

If you want to determine the pre-tax cost of debt, multiply the total amount of debt you have by your average interest rate. To find out how much your debt costs after taxes, multiply your interest rate by the result of one minus your effective tax rate. Then multiply this figure by the total amount of debt you have.