Interest rate is rising, and it will likely increase the amount you need to pay towards your debt. Do you know how to calculate your debt payments? It’s a good idea to learn how to see how it impacts your monthly cash flows. Continue reading to learn how.
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How To Calculate The Cost Of Debt
Calculating the cost of debt is important for individuals and businesses so as to know when the debt can be completely paid off using the current income. You can calculate your total pre-tax debt and after-tax debt. The first step to calculating the cost of your pre-tax debt is to know the annual interest rates of all the debts. Then you go ahead to calculate the following:
- Do a calculation of the total interest expense of your debts for the year. It will be good to have your financial statements as it will make the calculation much easier. You can break down the calculation to quarterly and then add it up for the whole year.
- Add up the principal sum of all your debts. Accuracy is very important. You do not want to under-calculate or over-calculate.
- The final part is dividing the total interest rate for the year by the total cost of the principal sum of your debt. This will give you the cost of your debt.
For example, if you have a debt of $100,000 with a 5% interest rate and a $50,000 debt with an interest rate of6%.
Your total annual interest will be calculated as follows: (5% x $100,000) = $5,000 plus (6% x $50,000) = $3,000. This makes it $8,000 in total. The total amount of debt is $150,000.
Therefore, you cost of debt is $8,000 /$150,000 x 100 = 5.3%. The effective pre-tax interest rate you are paying on your debt is 5.3%
An alternative is to calculate the total average debt for each quarter and add it all up. You should get your cost of debt.
Calculating your after-tax calculation is a bit different. Interest payments are tax-deductible and typically affect how you file your taxes at the end of the year. Most people prefer to calculate their after-tax cost of debt than the pre-tax cost of debt. To calculate your after-tax cost of debt after factoring in your taxes, you multiply your effective interest rate from your pre-tax calculation by (1 – t.) t being your tax rate.
To calculate your after-tax cost of debt, you multiply the effective tax rate you calculated in the previous section by (1 – t), where t is your company’s effective tax rate.
Using the previous example, your cost of debt is 5.3% and your tax rate is 20%. Therefore, 5.3%(1 – 20%) = 5.3% x (0.20)= 1.06%. your after-tax cost of debt is 1.6%.
What Is Cost Of Debt?
The cost of debt is referred to as the interest rate that a business pays on its debts. It is a concept mostly used by companies and businesses that have a debt profile with different creditors. It applies to all outstanding amounts like bonds and loans owed by the business. Cost of debt is a good way to assess the financial health of the business. Most companies calculate their cost of debt after tax considerations. This is because interest expenses on debts are tax-deductible. Therefore, the after-tax cost of debt is usually less than the before-tax cost of debt.
Cost of debt is also used as a corporate finance metric that investors, creditors and investment bankers use to analyze and assess a company’s capital structure. This informs their decision to invest in the company or not.
How Does Cost Of Debt Work?
Businesses taking out debt is almost like a norm because, for most businesses, it is always necessary to incur these debts before profit can be made. This makes debt and equity part of a company’s capital structure. A company’s capital structure consists of all the finances of its overall growth and operations through different sources of funds which may include debt financing. The measurement of the cost of debt of a company will go a long way in understanding the overall interest rates being paid by the company. This gives potential investors the risk level of investing in such a company. Typically, a company with a high cost of debt has a high risk of investment.
Companies consider their existing cost of debts and the potential income growth the debts will bring before taking new debts. For example, a company with a low cost of debt may consider taking out another loan of $1,000,000 for expansion in another city, if the new branch is expected to gain at least twice that amount in profit in the first year of operation. This may not be such an easy decision for a company with a high cost of debt will think twice before taking such a loan. The cost of debts of a business is a factor in almost every major business decision of a company, its investors and potential investors and creditors.
How To Lower Your Cost Of Debt
Assessing and analyzing the cost of debt of your business is essential to you taking up further debts and also servicing the existing debts. For a business to thrive, it is essential it always makes sure that it either has a low cost of debt or cost of debt at all. If your business has a higher cost of debt, here are some tips to lower it.
1. Improve Your Credit Score
For a business, your credit worthiness determines how much you will be able to access credit from other investors and creditors. It also determines your interest rates on the loans you take out. Improving your credit score will go along way to reduce the interest rate your company pays on subsequent loans. To improve your credit score, you will need to reduce your reliance on loans and repay existing debts. It is important you always check your credit report to know where your business stands in its cost of debt and also check for errors that may affect your credit score.
2. Repay Your Debts Faster
The principal sum of a loan may not necessarily be difficult to pay. What makes it difficult is the accumulating interest rates. This is what adds to what you will pay and most times makes it difficult to settle debts quickly. The solution to this is to have an aggressive approach toward repaying the debt as soon as possible. This prevents the interest rates from accumulating. Some lenders allow extra payments on your debt which will help you repay faster. Some creditors charge exit fees for paying down a loan before the repayment terms have been met. You can avoid these extra fees by renegotiating the repayment terms of the loan.
3. Negotiate Lower Interest Rates
For most businesses, the interest rate makes it difficult to fully repay a loan. However, you can always renegotiate the default interest rate attached to the loan. This may not work all the time, but it is good to always give it a try. This will go a long way in reducing your cost of debt. To convince most creditors to lower their interest rates, your company must prove that you are credit-worthy. You can successfully prove this by using your business or personal assets as collateral. You can also get a guarantor to sign for your loan. If you are able to do this, even if the creditor does not lower the interest rate at the initial stage, they may be willing with time. Another trick is paying more than your minimum payment and paying on time may encourage the creditor to lower your interest rate.
4. Refinancing Your Loan
Refinancing a business loan is the process of taking a new loan to repay existing ones. This is a dicey way of lowering your cost of debt. If you decide to do this, you should consider what the terms of the new loan are. To make the new loan effective in helping you to reduce the cost of debt, you must ensure that the new loan has favourable terms and interest rates. You do not want to take out another loan that will prove difficult to repay later. You can approach your existing creditors or new ones for a loan to refinance your existing debts. There are other costs that should also be considered before taking out another loan. Legal costs, credit cheques and other fees must be considered before going for a new loan to refinance your existing debts.
This is preferable if you have a single creditor or you have more than one debt profile with a single creditor. You may choose to negotiate with the creditor to consolidate all your company’s debt into one. This will mean you will be paying a single interest rate on your debt instead of the multiple interest rates you have been paying. This will ensure that you repay the loan on time.
6. Sourcing Funds From Your Investments
For a company that has investment vehicles where its monies are tied, you may choose to liquidate some of the investments in order to reduce your cost of debt. Stocks and bonds are usually suitable for this. It helps to clear some debts in your books at the cost of losing some of the company’s assets.
WACC is used for calculating the cost of debt and the potential of financial success for business projects. If you’re looking for personal financial planning you want to look at capitalization rate.
Cost of debt is the WACC for a corporation that has many assets and debts. It should not be used for personal financial planning calculations.