Jake phoned me six months after starting his roofing business. “This loan’s killing me, man.” “What’d you expect? You knew it was 6%.” “Yes, but it feels 10 times as expensive.” That’s the funny thing… Jake never even realized what that debt was costing him. He never did the math, he said; he simply glanced at the interest rate advertised by the bank and went with it. Spoiler: it wasn’t. Most business owners do this. They see a number, sign the papers, and then ask why their cash flow is tighter than anticipated. Jake could’ve saved himself so much trouble if he had learned the cost of debt formula.
What You’re Actually Measuring
Your business borrows money. It could be from a bank, a credit line, bonds, or what have you. Interest is charged on that money. The cost of debt tells you what percentage of the amount borrowed you’re actually paying. Whatever you paid in interest last year, take it. Divide by your total debt. Multiply by 100. That’s your percentage. Paid $3,000 in interest on $50,000? Your cost is 6%. Math checks out so far. But wait. Then there’s this thing called taxes that completely muddies the waters. The IRS lets you deduct business interest, which means you’re not actually paying the full 6%. More on that in a sec.
Basic Version First
- Pre-tax cost of debt formula goes like this:
- Cost of Debt = (Total Interest ÷ Total Debt) × 100
- Jake’s situation as a cost of debt formula with example: He borrowed $50,000 at 6%. Paid $3,000 in interest over the year.
- $3,000 ÷ $50,000 = 0.06 Times 100 = 6%
Matches what his bank told him. Except this ignores something huge.
Where Taxes Change Everything
Interest payments reduce your taxable income. Every dollar you pay in interest means one less dollar the government can tax you on. Jake’s in the 25% tax bracket. So every dollar of interest effectively costs him 75 cents because he’s saving 25 cents in taxes. After-tax cost of debt formula looks like this:
- After-Tax Cost = Pre-Tax Cost × (1 – Tax Rate)
- For Jake: 6% × (1 – 0.25) = 6% × 0.75 = 4.5%
- His real cost isn’t 6%. It’s 4.5%. Uncle Sam’s basically chipping in 1.5% through tax savings.
Finance people write this as kd = 4.5% because writing “after-tax cost of debt” a hundred times gets old fast.
Why This Actually Matters
When Jake was thinking about whether to borrow or save cash, he needed to think about the real cost of 4.5%, not the sticker price of 6%. At 4.5 per cent, getting the loan was a no-brainer. He could make at least that much, if not more, on roofing jobs. If it were really 6%, the math would’ve been tighter. That 1.5% gap? Huge difference in whether borrowing was smart or stupid. Big companies calculate this constantly when they’re deciding between debt and equity. Debt’s usually cheaper because of that tax break, assuming you actually crunch the numbers.
When You’ve Got Multiple Loans
Jake doesn’t just have one loan anymore. He’s got:
- Original $50,000 term loan at 6%
- $20,000 credit line at 8%
- $10,000 on a business credit card at 12%
To find his overall cost, add up all interest from everywhere, then divide by the total debt. His annual interest payments:
- Term loan: $3,000
- Credit line: $1,600
- Card: $1,200
Total interest: $5,800 Total debt: $80,000 Pre-tax cost: $5,800 ÷ $80,000 = 0.0725, or 7.25% After-tax with his 25% rate: 7.25% × 0.75 = 5.44% His blended real cost is 5.44%. Higher than the original loan because he’s paying through the nose on that credit card.
Shortcuts Exist But You Should Still Know the Math
Sure, you can Google “cost of debt calculator“ and plug in numbers. Takes 30 seconds. But doing it yourself means you actually understand where your money’s going. It’s not complicated math. Anybody with a phone calculator can handle it. In Excel? Even easier. Make columns for each loan amount and interest payment. Add them up. Divide. Multiply by your tax adjustment. Boom, done.
Things Get Messier With Bonds
The standard formula works fine for regular business loans. Gets weird with bonds or complex instruments. Bonds trade on the market, so you’d use yield to maturity instead of just dividing interest by face value. That accounts for whether people are paying more or less than the bond’s worth. Most small businesses won’t deal with this. But if you’re looking at the cost of debenture formula or other securities, just know there are different versions depending on what type of debt you’re measuring.
What’s Actually a Good Number?
Depends on what industry you’re in and what you’re doing with the cash. Manufacturing companies with tons of equipment often run 5-7% after tax. Service businesses might be lower because banks see them as safer bets. The magic isn’t hitting some specific percentage. It’s making sure your cost of debt is less than what you’re making with that borrowed money, and borrowing at 5% to invest in equipment that returns 15%? Great move. Borrowing at 8% to fund something that only makes 6%? You’re losing money. Jake figured this out eventually.
His original loan at 4.5% effective cost funded tools and a truck. Those let him take bigger jobs that paid way more than 4.5%. So the debt paid for itself plus extra. That credit card debt is at 9% after taxes? Just covering expenses when cash ran short. Not making him any money, just keeping the lights on. He paid that sucker off ASAP because it was dragging him down.
Taxes Can Screw You Over
Here’s something Jake learned the hard way. During a year, his business lost money, so the tax deduction was worthless. No profit means no taxes to reduce. His after-tax cost that year equaled his pre-tax cost. Debt got more expensive right when he could least afford it. This is why any after-tax cost of debt calculator needs your current year’s situation. Last year’s tax rate might be totally wrong for this year.
Actually Using This When Loan Shopping
Next time someone offers you financing, do the math yourself. You should not rely only on the rate they are advertising. Account for fees—those raise your real cost. Account for your tax bracket—that lowers it. Then take that actual cost and compare it to what you expect to make with whatever it is you’re financing. Last month Jake forwarded me a loan offer to review. The bank quoted 5.5%.
But there was a 2% origination fee, which brought the first-year cost to 7.5%. After taxes, that fell to 5.6%. Still more than his current debt, so he told them no thank you. He almost took it based on that 5.5% headline number. Actually running the cost of debt formula saved him from an expensive screw-up.
Real Talk
This formula isn’t rocket science. Interest divided by debt, adjusted for taxes. Maybe a minute of calculation. But that minute can save you thousands in bad financing choices. Or help you spot opportunities when debt’s actually cheaper than alternatives. Jake’s business is crushing it now. He knows what every loan costs, factors that into decisions, and only borrows when it pencils out.
That’s the whole point here. Know what you’re paying. Know what you’re getting. Make sure number two beats number one. Simple stuff once you stop ignoring the math.