At the most basic level, debt is money that one person or entity owes to another person or entity. However, if you’ve ever taken out a loan or opened a line of credit, you know that — although the concept is simple — there are a variety of factors that make debt more complicated than it seems.
Many of those complications relate to calculating the cost of debt, which is what this post will cover. When you’re finished reading, you’ll know how to calculate the cost of debt.
What is the Cost of Debt?
When it comes to debt, regardless of what type it is, there are a variety of costs you may pay. Generally, these costs occur when you first incur the debt and/or during the life of the debt. In some cases, you’ll incur costs in the form of a prepayment penalty when you pay off a loan
For example, consider a hypothetical business loan
with an interest-only period of one year at the end of which a balloon payment is due. When you incur that debt, you’ll pay closing costs such as origination fees or points. During the life of that loan, you’ll pay interest based on a given interest rate and the amount of your loan with periodic payments. Finally, at the end of one year, you’ll pay the balloon payment.
To calculate the cost of the debt on this loan, you’d add up the closing costs and interest payments.
You wouldn’t include the balloon payment because that repays the money you borrowed, also known as the “principal” of the loan. Paying back principal, though your accountant will note it down as an expense
, isn’t a cost of your debt. The cost of your debt, as mentioned, comes in the form of fees, interest, and penalties.
How to Calculate the Cost of Debt
Since there are so many different types of debt, it’s impossible to provide a single recipe that guides you a debt cost calculation step by step. However, there are useful guidelines that you can use and steps you can take to figure out exactly how much your debt costs, which we’ll review here.
1. Find Your Debt Balance:
Since the cost of your debt depends on the amount of debt you have, the first thing to find out is what your debt balance is.
2. Know Your Interest Rate:
To calculate your interest costs, you must multiply the interest rate on your debt by the balance of your debt, so you must know your interest rate.
3. Add Up All the Fees:
Different types of debt will carry different types of fees. To find the cost of your debt, you must include all fees such as origination fees, attorney’s fees, application fees, discount points, and broker fees.
Once you have all the information referenced in the steps above, you have all the ingredients you need to calculate the cost of any debt. Of course, various types of debt will be structured differently, so you’ll have to take the specific terms of your loan into consideration.
The last thing to note about calculating the debt cost is that, depending on the type of debt, the interest you pay may be tax-deductible. By applying tax-deductible interest to your income, you’ll reduce your taxable income which could save you money on your taxes. Of course, the extent to which tax-deductible interest will reduce your tax bill can vary considerably depending on your specific tax situation.
Knowing the cost of your debt is critical, whether you’re thinking about financing your business with debt or thinking about refinancing an existing debt. However, it’s important that you don’t just look at the cost of your debt. After all, the point of taking on debt is to grow your business, so make sure you’re evaluating the return on your investment relative to the cost of your debt.