These Cost of Debt Examples Will Blow Your Mind
Just about every business has some type of debt. There are a few businesses among us that have managed to exist in a debt free way. Unfortunately, that is not the majority. While many companies have debt, they do not truly understand how that debt impacts their business and financial situation. To get a better idea of how debt impacts your business, continue reading this article to learn about examples of the cost of debt.
What is Debt?
Before we can really look at the cost of debt, it is essential that you understand the definition of debt. A debt occurs when you borrow money from someone or a place, such as a bank. This creates a debt that you are obligated to repay. Before you are allowed to borrow the money, you sign a repayment agreement that outlines how much you will pay per month until the debt is repaid. There are consequences of not paying back the money. There are usually fees and interest charges charged by the entity that allows you to borrow the money.
As mentioned above, when you (or your business) take on a debt, you are taking on more than the amount of money you wish to borrow. There are fees and interest charges that accompany the amount you borrow. When you calculate the interest charges over the entire loan term, those charges create the cost of debt. When you calculate the cost of debt, it gives you a clear picture of how much the loan, or other debt, is going to cost you. This may help you decide how this is going to impact the finances of your business over the next few years.
How is Cost of Debt Calculated?
There are a number of ways the cost of debt can be calculated. The most common way to calculate this number looks like this:
That may not have made anything more straightforward for you, so let’s break down that calculation. The tax rate is the average income tax rate of your business. You can use your tax schedule to help you determine your tax rate. Your interest expense is the total cost of interest for each specific loan. The total interest cost may include any fees that you paid with the loan.
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Simplified Cost of Debt Example
That may not have helped clarify the cost of debt for you. Here is a simplified example to make it more clear.
You receive a loan for $100,000 with 10 percent interest, and your business average tax rate is 20 percent. Since this is a simple example, we are going to have all of the interest applied to the principal up front. There is no compounding of the interest. The interest your business is paying is $10,000.
Plugging the numbers above into the equation looks like this:
Cost of debt = 10,000 x (1 - .20)= 10,000 x 0.8 = $8,000
The cost of debt for the life of this loan equals $8,000. Once you have this number, you can compare it to the amount of income you can generate by having this loan. This helps you determine if this loan is a good investment for your business. If this loan is only going to generate $2,000 of income for you, it may not be the best idea for your business.
Complex Cost of Debt Example
The example above was an easy one, but they are not always that easy. More common are long-term installment loans where they are amortized. That means that the amount you pay in principal and interest changes over the course of the loan. When you first start paying on the loan, the majority of it goes to the interest. Then, as you move later into the repayment, you begin to pay down the principal.
When you have an amortized loan, you will have to determine the interest expenses for each loan payment. Then you have to add all of those personal expenses together to get the interest expense for the formula above. You can also get this number from an amortization schedule.
What Does an Amortization Schedule Look Like?
We will an example where you have taken on a $100,000 loan with 15 percent interest. If this is one year loan, your amortization schedule should look like this:
| Month | Starting Balance | Payment | Principle | Interest | Ending Balance |
|---|---|---|---|---|---|
| 1 | 100,000 | 9,025.83 | 7775.83 | 1250.00 | 92224.17 |
| 2 | 92,224.17 | 9,025.83 | 7873.03 | 1152.80 | 84,351.14 |
| 3 | 84, 351.14 | 9,025.83 | 7971.44 | 1054.39 | 76, 379.70 |
| 4 | 76, 379.70 | 9,025.83 | 8,071.08 | 954.75 | 68,308.62 |
While the table above does not show every payment you will make, it highlights how you pay more interest up front, and as you make more payments, you pay less interest and more principal. When you add up all the numbers in the interest column, it gives you the interest expense. While I did not take it all the way to the end, the total interest is $8309.97.
Lowering Cost of Debt
You may not like how much your debt costs you or your business. There are ways to lower your cost. First, you can pay off your loan faster, which means you pay less interest and have to make the payments for fewer months. This does mean you have to increase the amount you pay on your loan. Second, you can refinance your loan at a lower interest rate. Once you pay off some of the loan, you may be able to improve your credit and qualify for a lower interest loan. This can decrease the overall amount you end up paying for your loan.
Need More Help?
Now that you know how much your debt is costing your business, you may be interested in debt elimination or at least some tools for debt management. The Goalry Mall has everything you need to manage your debt better and decrease the cost. Check out the Goalry Mall to see all the resources we have to offer you. In addition, there are guides, fact sheets, and videos to help you reduce your debt and make better use of your business capital.
Conclusion
The financial picture of your business is essential to help you understand how your company can grow. It is essential for purchases you want to make today, but also in the future. Unfortunately, most organizations take on debt without a full understanding of what that means for the future of the business. When you have a clear understanding of the cost of your debt, you can make better decisions for your business.