# Cost of Debt: What It Means and Formulas

> **Definition**
>
> A company's cost of debt is the amount it pays in interest on debts used to finance its operations.

## What Is the Cost of Debt?

The cost of debt is the total interest expense paid for borrowing money. It is the effective interest rate that a company owes on any liabilities such as loans.

The size of the cost of debt depends on the borrower's creditworthiness, so higher costs generally mean the borrower is considered by lenders to be relatively risky.

Cost of debt can refer to either before-tax or after-tax cost of debt.  

### Key Takeaways

*   For companies, interest expenses are tax-deductible, meaning there is a key difference between the pretax cost of debt and the after-tax cost of debt.
*   Debt is one part of a company’s capital structure, with the other being equity. 
*   Calculating the cost of debt involves calculating the average interest paid on all of a company’s debts. 

![Cost of Debt](https://www.investopedia.com/thmb/-AyQpPleFRldS0q9pNAch5W4ErE=/1080x0/filters:no_upscale():max_bytes(150000):strip_icc()/costofdebt2-396ca7f9589d49c8a2ed985d631635e9.jpg)

*— Investopedia / Julie Bang*

## How the Cost of Debt Works

[Debt](https://www.investopedia.com/terms/d/debt.asp) is money owed by one person or entity to another. Business debt is unavoidable for most companies. Companies, like individuals, use debt to make large purchases or investments.

For corporations, debt is part of their [capital structure](https://www.investopedia.com/terms/c/capitalstructure.asp). Capital structure is the mix of debt and equity that a firm uses to finance its operations and fund its growth. The debt might consist of bonds, loans, or a mix of both.

A company's cost of debt is the overall rate being paid by a company to use these types of [debt financing](https://www.investopedia.com/terms/d/debtfinancing.asp). This gives investors an idea of the company’s risk level compared to others, as riskier companies generally have a higher cost of debt.

> **Important**
>
> The cost of debt is generally lower than cost of equity.

## Formula and Calculation of Cost of Debt

There are a couple of different ways to calculate a company’s cost of debt, depending on the information available.  

### After-Tax Cost of Debt

One way to calculate the cost of debt is by using the formula for the after-tax cost of debt:

> $\begin{aligned}&\text{ATCD} = (\text{RFRR} + \text{CS}) \times (1 - \text{Tax Rate})\\&\textbf{where:}\\&\text{ATCD}=\text{After-tax cost of debt}\\&\text{RFRR}=\text{Risk-free rate of return}\\&\text{CS}=\text{Credit spread}\end{aligned}$

The [risk-free rate of return](https://www.investopedia.com/articles/financial-theory/08/risk-free-rate-return.asp) is the theoretical rate of return of an investment with zero risk, most commonly associated with U.S. Treasury bonds.

A credit spread is the difference in yield between a U.S. Treasury bond and another [debt security](https://www.investopedia.com/terms/d/debtsecurity.asp) of the same maturity but different credit quality.

This formula is useful because it takes into account fluctuations in the economy, as well as company-specific debt usage and credit rating. If the company has more debt or a low [credit rating](https://www.investopedia.com/terms/c/creditrating.asp), then its credit spread will be higher.

For example, say the risk-free rate of return is 1.5% and the company’s credit spread is 3%. Its pretax cost of debt is 4.5%. If its tax rate is 30%, then the after-tax cost of debt is 3.15%. We can calculate this in the following way:

**\[ ( 0.015 + 0.03 ) x ( 1 - 0.3 ) \]**  

#### Before-Tax Cost of Debt

Another way to calculate the cost of debt is to determine the total amount of interest paid on each debt for the year.

The interest rate that a company pays on its debts includes both the risk-free rate of return and the [credit spread](https://www.investopedia.com/terms/c/creditspread.asp) from the formula above because lenders take both into account when determining an interest rate.

Once the company has its total interest paid for the year, it divides this number by the total of all of its debt. This is the company’s average interest rate on all of its debt.

For example, say a company has a $1 million loan with a 5% interest rate and a $200,000 loan with a 6% rate. The average interest rate and its pretax cost of debt is 5.17%. This is calculated as follows:

> $\begin{aligned}\frac{(\$1 \text{ million}\times0.05) + (\$200,000\times0.06)}{\$1,200,000}\end{aligned}$

The company’s tax rate is 30%, which means its after-tax cost of debt is 3.62%. To calculate this, we use the following formula:

> $\begin{aligned}[0.0517 \times (1 - 0.30)]\end{aligned}$  
> 
> > **Fast Fact**
> >
> > The cost of debt before taking taxes into account is called the before-tax cost of debt. The after-tax cost of debt factors in taxation. The key difference lies in the fact that interest expenses are tax-deductible business expenses.
> 
> ## Impact of Taxes on Cost of Debt
> 
> Since the interest paid on debts is often treated favorably by U.S. [tax codes](https://www.investopedia.com/terms/t/tax-code.asp), the tax deductions due to outstanding debts can lower the effective cost of debt paid by a borrower.
> 
> The after-tax cost of debt is the interest paid on debt less any income tax savings due to deductible interest expenses. To calculate the after-tax cost of debt, subtract a company’s effective tax rate from one, and multiply the difference by its cost of debt.
> 
> The company’s [marginal tax rate](https://www.investopedia.com/terms/m/marginaltaxrate.asp) is not used. Instead, the company’s state and federal tax rates are added together to ascertain its effective tax rate.
> 
> For example, if a company’s only debt is a [bond](https://www.investopedia.com/terms/b/bond.asp) that it issued with a 5% rate, then its pretax cost of debt is 5%. If its effective tax rate is 30%, then the difference between 100% and 30% is 70%, and 70% of the 5% is 3.5%. The after-tax cost of debt is 3.5%.
> 
> The rationale behind this calculation is based on the tax savings that the company receives from claiming its interest as a business expense.
> 
> Using the example, imagine the company issued $100,000 in bonds at a 5% rate with annual interest payments of $5,000. It claims this amount as an expense, which lowers the company’s income by $5,000. As the company pays a 30% tax rate, it saves $1,500 in taxes by writing off its interest. As a result, the company effectively only pays $3,500 on its debt.
> 
> This equates to a 3.5% interest rate on its debt.
> 
> ## How to Reduce Cost of Debt
> 
> Businesses can reduce the cost of debt in the same ways that individuals can. The following are just a few of the ways to do so:
> 
> *   **Negotiating Rates**: Some lenders will offer a certain rate upfront. But you don't have to accept the rate they give you. Many lenders may be willing to work with you because they want your business.
> *   **Refinancing**: Consider refinancing if interest rates drop or your situation changes, and you're in a position to secure a better rate. People often do this with their mortgages when interest rates fall. This allows them to cut their monthly [mortgage payments](https://www.investopedia.com/mortgage/mortgage-rates/payment-structure/).
> *   **Increase Payments**: If you pay more than the required monthly payment, you'll lower your principal balance and reduce the amount of interest you'll pay over the life of the debt.
> *   **Improving Credit Scores**: Your [credit score](https://www.investopedia.com/terms/c/credit_score.asp) determines the rate you're going to get. Improving your score will help you get a lower rate. You can do this by maintaining your payments or paying off existing debt. Check your credit report regularly to ensure there are no errors.
> 
> ## Example of Cost of Debt
> 
> Suppose you run a small business and you have two loans that are helping finance the enterprise. The first is a loan worth $250,000 through a major financial institution. The second is a $150,000 loan through a private investor. The first loan has an interest rate of 5% and the second one has a rate of 4.5%.
> 
> First, let's calculate the total amount of interest you'll pay each year on both of these loans:
> 
> *   Loan # 1: $250,000 x 5% = $12,500
> *   Loan # 2: $150,000 x 4.5% = $6,750
> 
> We can add these two figures together to get the total annual interest, which is $19,250.
> 
> In order to calculate the effective rate before taxes, we divide this figure by the total amount of the debt:
> 
> $\begin{aligned}\frac{\$19,250}{\$400,000} = 0.0481\end{aligned}$
> 
> Therefore, the effective before-tax rate of these debts is 4.81%
> 
> ## Why Does Debt Have a Cost?
> 
> Lenders require that borrowers pay back the principal amount of debt plus interest. The interest rate, or yield, demanded by creditors is the cost of debt.
> 
> The interest repays the lender for the [time value of money](https://www.investopedia.com/terms/t/timevalueofmoney.asp) (TVM), inflation, and the risk that the loan will not be repaid. It also accounts for the [opportunity costs](https://www.investopedia.com/terms/o/opportunitycost.asp) associated with the money not being invested elsewhere.
> 
> ## What Makes the Cost of Debt Increase?
> 
> Several factors can increase the cost of debt, depending on the level of risk to the lender. These include a longer payback period, since the longer the payback period is the greater the time value of money and opportunity costs. The riskier the borrower is, the greater the cost of debt since there is a higher chance that the borrower will default.
> 
> Unsecured debts have higher costs than loans that include [collateral](https://www.investopedia.com/terms/c/collateral.asp).
> 
> ## How Do Cost of Debt and Cost of Equity Differ?
> 
> A mix of debt and equity capital provides businesses with the money they need to maintain their day-to-day operations.
> 
> Equity capital tends to be more expensive for companies and does not involve a favorable tax treatment. Too much debt financing will damage creditworthiness and increase the risk of default or bankruptcy.
> 
> Given these factors, businesses strive to optimize their [weighted average cost of capital](https://www.investopedia.com/terms/w/wacc.asp) (WACC) across debt and equity.
> 
> ## What Is the Agency Cost of Debt?
> 
> The [agency cost of debt](https://www.investopedia.com/terms/a/agency-cost-of-debt.asp) is the conflict that arises between shareholders and debtholders of a public company when debtholders place limits on the use of the firm’s capital if they believe that management will take actions that favor equity shareholders instead of debtholders.
> 
> In response, debtholders will place covenants on the use of capital, such as adherence to certain financial metrics which, if broken, allows the debtholders to call back their capital.
> 
> ## The Bottom Line
> 
> Debt is unavoidable for most people and businesses. But it comes at a price. This is referred to as the cost of debt.
> 
> The cost of debt is calculated by multiplying the value of a loan by the annual interest rate. To determine the [effective interest rate](https://www.investopedia.com/ask/answers/031615/how-do-interest-rates-influence-corporations-capital-structure.asp), add together all that interest by the total amount of debt.

> **Article Sources**
>
> 1.  Financial Industry Regulatory Authority. "[Spread the Word: What You Need to Know About Bond Spreads](https://www.finra.org/investors/insights/spread-word-what-you-need-know-about-bond-spreads)."
>     
> 2.  Internal Revenue Service. "[Topic No. 505, Interest Expense](https://www.irs.gov/taxtopics/tc505)."
>     
> 3.  Internal Revenue Service. "[Publication 334, Tax Guide for Small Business](https://www.irs.gov/pub/irs-pdf/p334.pdf)." Pages 34-35.