There are a variety of costs you might pay when it comes to debt. Generally, these costs occur when you incur the debt and/or payment during the life of the debt. You may incur costs in the form of a prepayment penalty when you pay off a loan early.
Consider a 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. At the end of the year, you will pay the balloon payment.
To calculate the cost of the debt, you’d add up the closing costs and interest payments. The balloon payment is not included 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, is not a sot of your debt. The cost of your debt comes in the form of fees, interest, and penalties.
How to Calculate the Cost of Debt
Since there are different types of debt, it is impossible to calculate the cost of debt step by step. There are useful guidelines you can use and steps you can take to figure out how much your debt costs.
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.
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.
Add Up All the Fees
Different types of debt will carry different fees. To find the cost of your debt, you need to include all fees such as origination fees, attorney fees, application fees, and broker fees.
As soon as you have all the above information, you can begin to calculate the cost of any debt. Of course, various types of debt will be structured differently so you will have to take the specific terms of your loan into consideration.
The last thing to remember is that depending on the type of debt, the interest you pay might be tax-deductible. By applying tax-deductible interest to your income, you will reduce your taxable income which could save you money on your taxes.
The Bottom Line
Knowing the cost of your debt is critical whether you are thinking about financing your business with debt or thinking about refinancing an existing debt. However, it is important that you do not just look at the cost of your debt. The point of taking on debt is to grow your business, so make sure you are evaluating the return on your investment relative to the cost of your debt.