When shopping for business loans, it’s extremely important to know each option’s true cost. At first, that seems pretty easy: you just calculate the loan’s APR, right? This might help you determine the cheapest option available. But when you think of the big picture, it becomes clear that APR does not account for numerous other factors that affect the cost of the debt.
For example, many businesses take advantage of business loans primarily because they can deduct interest payments from their taxes. Then there’s the amount of revenue your business stands to generate from the loan. Both factors could dramatically lower the loan’s long-term cost.
Any experienced business owner knows not to accept external funding without eliminating any uncertainties in regards to cost. You can do this by calculating the loan’s cost of debt. Applying this simple formula will confirm whether an option’s potential for income growth indeed surpasses its cost.
Business owners tend to get so wrapped up in statistics like interest rate, payment frequency and payment size that they forget about the loan’s purpose. Understanding cost of debt ultimately makes it easier to justify taking on the amount of debt that directly coincides with your business’s goals.
In this guide, we’ll explain how to calculate cost of debt, how it affects your options for business loans, and how to lower the cost of debt for your next loan.
What is Cost of Debt?
By definition, cost of debt refers to the total amount of interest the borrower pays over the full term of the loan. Unlike other formulas used to measure the cost of business loans, cost of debt accounts for tax deductions on interest payments.
Business owners often calculate cost of debt primarily to compare it to their projected income growth after receiving additional capital. This number can therefore determine if the amount of money you’d owe outweighs the loan’s financial benefits. Proving that an option will bring in more money than it costs can also reveal the loan’s capacity to increase profits.
For many business owners, choosing the right business loan means finding the lowest interest rate. The criteria for “low,” however, depends on the loan’s purpose. For example, one financial institution might offer the exact amount you asked for, but not at the interest rate you imagined. But then you remember that this amount of money will most likely triple your customer base. Despite its moderate interest rate, the loan’s benefits still outweigh its cost.
Financial institutions can also base their decisions on how the cost of debt compares to your projections. They might look at your business plan and conclude that the purpose of the loan does not have the potential to pay off the cost.
How to Calculate Cost of Debt
Different financial professionals use different formulas to calculate cost of debt. Here’s the most common:
Cost of Debt = Interest Expense (1 – Tax Rate)
As you can see, the formula involves just two figures: interest expense and tax rate. The ambiguity of each figure makes this seemingly simple equation much more complicated. Different financial institutions present and advertise their interest expense in different ways. For example, one institution might quote an APR, while another might give you the total payback amount.
Tax rate also refers to your business’s average income tax rate, which must account for federal, state, and local taxes. You can’t just find this figure on last year’s tax returns, partially because your tax bracket may have changed following recent tax reform laws.
It’s your accountant’s job to know your average income tax rate. But if you want to figure it out for yourself, divide your total tax liability (how much you owe per year) by your total taxable income.
“Interest expense” refers to the total interest cost of the loan throughout its full term. This includes all loan fees you can deduct on your taxes. Since most institutions don’t advertise their total interest expense, you’re going to have to ask for it. Theoretically, you should do this for every business loan on the table.
Now that you’ve got the formula’s two figures, you can go ahead and calculate the cost of debt. In the following section, we’ll show two examples of the formula in action. The second will account for another thing that can complicate cost of debt: compounding or amortization.
Cost of Debt: Easy Example
The length of time it takes to calculate cost of debt depends on how long it takes to produce the two required figures. In this example, a $90,000 loan has an interest rate of 12%. The business has an average tax rate of 20%. With no compounding or amortization to worry about, you can just use the advertised 12% interest rate.
Let’s apply those numbers to the cost of debt formula:
12% of 90,000 = 10,800
10,800 (1 – .20) = 10,800 x .8 = $8,640
This means that throughout the full term of the loan, the borrower will pay $8,640. You can’t call that number “high” or “low,” however, until you compare it to your projections for income growth. This will essentially tell you whether or not the loan offers an ROI.
In this example, let’s say the business plans to use the loan to make investments capable of generating at least $30,000 in revenue. That number far surpasses the cost of debt, which officially makes this loan an advantageous option.
If the borrowed funds only had the potential to generate closer to $10,000, on the other hand, you might want to look for other options. Sometimes, you have to calculate the cost of debt for several loans before you find one that offers the most affordable interest rate and terms.
Cost of Debt: Complex Example
Many business term loans have amortization schedules. This means that over the term of the loan, different portions of your payments will go towards the amount borrowed (the “principle”) and the interest.
In most cases, the majority of your earliest payments will go towards interest. When you reach the middle or end of the term, the majority of the payment goes towards the principle.
Finding cost of debt for this type of loan starts with the amortization schedule. This will show the interest expense of each payment. Adding up the interest expenses for each payment over the course of one year will give you your “interest expense,” the first figure in the formula.
So, let’s say the borrower has five years to pay back the aforementioned $80,000 loan. The amortization schedule shows that after one year, the borrower will have paid $6,000 in interest.
Here’s how to calculate the cost of debt for this loan:
6,000 (1 – .20) = $4,800
Unsurprisingly, the longer terms make the cost of debt per year lower. However, the longer the amortization term, the higher overall cost of the loan if you take the whole term of the loan to pay it back. To find out whether the loan’s potential for income growth surpasses its cost, estimate how much revenue it will generate in one year’s time.
What About Fees?
Most business loans come with several fees. This can include loan origination fees, document preparation fees, processing fees, credit check fees, etc. You need to account for non-tax deductible fees in order to ensure an accurate cost of debt.
Instead of adding them to your interest expense, just add them to the final calculation. But remember; this only applies to non-tax deductible fees. You wouldn’t include deductible fees because you don’t actually have to pay them. Deciding which fees you can and cannot deduct can get complicated, so you’ll want to talk to your accountant before making any assumptions.
For example, while borrowers can usually deduct loan origination fees (or “application” fees), they cannot deduct packaging fees.
How to Lower Your Cost of Debt
You shouldn’t begin shopping for business loans if you have any doubt that your business can sustain this much debt at this time. In other words, you must first determine whether or not you’re truly ready to take on additional debt. You can do this by seeing what kind of options you can qualify for and calculating their cost of debt.
But after doing some calculations, you might conclude that neither option yields an affordable answer. In this case, you should probably turn your focus to lowering your cost of debt. This doesn’t necessarily mean you have to stop your search.
Here’s how to decrease the cost of debt for your next business loan:
Lower Your Interest Rate
Nothing will decrease your cost of debt quicker than becoming eligible for lower interest rates. So, think of the many ways aspiring borrowers can gain access to the most affordable business loans.
Regardless of which institution you work with, credit score remains the top requirement for lower interest and longer terms. How can you raise your credit score? To start, you could reduce your credit utilization rate, pay off debts with the highest interest rates, and check your credit report for any errors. You can also gain access to more affordable options by putting up collateral. This could include business assets like expensive equipment or personal assets like your house or car.
Finally, ask your institution if it’s possible to eventually decrease your interest rate as long as you continue to make timely payments.
You might think that lowering your interest rate just two or three percentage points won’t save you much money. If so, test this theory with the cost of debt formula. You will discover that decreasing an interest rate from, say, 17% to 14%, could lead to massive savings, especially for loans with longer terms.
Take Out a Second Loan
The previous section mentioned asking your institution to lower your interest mid-way into your repayment process. Even if the institution says no, you should still make moves to raise your credit score, increase revenue, and improve cash flow. This could make you eligible for another, much cheaper loan from the same institution or an entirely different one. Yes, plenty of institutions have no issue approving borrowers with existing loans.
You could use this second loan to pay off the first, and your monthly payments would decrease due to the lower rate and longer terms. Keep in mind, however, that each institution has their own requirements for approving borrowers with existing loans. In addition to increasing revenue and raising your credit score, you might have to improve profitability or reach an age-related milestone (2 years in business, etc.).
Start with a Smaller Loan
Institutions like United Capital Source offer another quick path to cheaper loans. Rather than trying to raise your credit score or increase revenue before applying, you take the most advantageous short-term loan you can get right now. Rest assured, these companies do not deliberately distribute loans that new clients will clearly struggle to pay back.
In as little as three to four months, you will have paid off the loan in full. The institution now has proof of your ability to make timely payments without endangering cash flow. Thus, paying off this small, slightly expensive loan will almost certainly make you eligible for more convenient terms and lower rates.
Increase Potential for Revenue Growth
We’ve repeatedly emphasized that your cost of debt only becomes “low” or “high” after comparing it to your projections for income growth. Hence, raising those projections effectively lowers your cost of debt.
For example, let’s say you plan on generating $20,000 with the borrowed funds. Well, what if you restructured your strategy so that it could generate closer to $30,000? This would allow you to accept business loans with higher interest rates. Options that you may have previously dismissed as too expensive would now become fairly reasonable.
This shouldn’t require you to use your loan for an entirely different purpose. Trying to think of another plan so late in the game would likely increase the risk of failure.
Instead, you should look to make some minor adjustments to your current plan. This could include raising your prices, adding new details to your advertisements, or even speaking to another supplier to decrease the cost of goods sold and increase profitability.
Look for Shorter Terms
Small business loans with shorter terms typically have higher interest rates. Their cost of debt, however, tends to run on the low side because you’d only have to make interest payments for less than one year.
Shorter terms can also lower your cost of debt when comparing business term loans of the same amount. For example, let’s say your research yields two $100,000 business term loans with dramatically different terms (5 years vs 10 years) but relatively similar interest rates (15% vs
12%). The ten-year loan would have lower monthly payments. Its cost of debt, on the other hand, would likely surpass the five-year loan by at least $10,000. Since you have two similar interest rates, the massive discrepancy in terms significantly impacts the ten-year loan’s cost of debt.
How Does APR Affect Cost of Debt?
You’ve probably heard that unless you have poor credit or need funding right away, you should avoid short term business loans. These loans carry high APRs due to the increased risk on behalf of the institution. Therefore, over the course of one year, you’d pay more interest than you would with an SBA Loan, or any other option with longer terms.
But remember: APR only applies to that time frame: one year. Cost of debt, however, measures the total interest expense over the loan’s full term. With short-term loans, you might only have to make interest payments for three to four months. So, while an SBA Loan might cost you less over the course of one year, the cost of its full term would far surpass what you’d pay with shorter terms.
Loan Products with a Low Cost of Debt
As you can see, the business loans with the shortest terms tend to have the lowest costs of debt. Multiple types of business loans have short terms but very different repayment structures and borrowing limits. Below, you will find descriptions of these loans along with their typical interest rates:
Each institution has its own definition of “short,” but most short-term business loans carry terms of four to eighteen months. The shortened terms eliminate the need for interest payments, but this can also vary from institution to institution. You can borrow as little as $1,000 and up to $250,000. Interest rates start at 10%, though the maximum APR can reportedly exceed 25%.
Business Line of Credit
After approval, you can borrow from your business line of credit at any time. You only pay interest on borrowed funds, so your rate depends on how long it takes you to pay off the amount you owe. In the case of revolving lines of credit, you can keep borrowing as long as you continue to pay back the total amount you just borrowed.
Once you pay off the total balance, the credit line replenishes. You can borrow $1,000 all the way up to $1 million, with terms ranging from six months to five years. Interest rates typically start at 7% but can range as high as 99%.
Working Capital Loan
Similar terms and interest as short term business loans, but the borrowing amount stems directly from the monthly costs of running your business. You can borrow $10,000 to $5 million, with interest rates starting at 9%.
If you have an unpaid invoice, you can sell it to an institution for approximately 85-90% of the original value with accounts receivable factoring. The institution pays you this money right away and takes responsibility for collecting from your customer.
When the customer pays the institution, you will receive the remainder of the original value, minus another percentage. Instead of interest payments, the institution deducts percentages known as “factor rates.” They typically start at around 5%.
Not Sure About That Loan? Calculate Cost of Debt
For many business owners, an appropriately-priced business loan simply means reasonable monthly payments and APR. While both metrics can provide valuable insight of the loan’s cost, they cannot confirm whether the loan makes sense from an investment perspective. That’s where cost of debt comes in. If anything, it simply helps borrowers remember why they applied in the first place: to grow their income and make the repayment process as seamless as possible.