What Is the Cost of Debt? (And How to Calculate It)

Knowing your after-tax cost of debt is a critical performance indicator. It tells you whether your business is riding the waves or slowly sinking to the bottom.

You’re sitting down with your accountant, reviewing your business’s financial statements. You’ve got a $200,000 term loan at 8%, a $50,000 line of credit at 12%, and a $30,000 equipment loan at 6.5%. Your accountant asks, “Do you know your overall cost of debt?” You pause.

You know what you’re paying on each loan individually, but what does it all add up to?

More importantly, should you be concerned?

Understanding your cost of debt isn’t just an academic exercise—it’s a critical metric that determines whether borrowing makes financial sense for your business.

According to the U.S. Federal Reserve, 43% of small businesses seek external funding at some point, most often through some form of debt. Knowing your true cost of debt helps you decide whether taking on financing will increase profitability or drain it.

Let’s break down exactly what the cost of debt means, how to calculate it properly, why the after-tax number matters more than the headline rate, and how to use this information to make smarter financing decisions.

What is the Cost of Debt and Why Does It Matter?

The cost of debt is the effective interest rate your business pays on all its borrowed money. It’s the return that lenders and creditors require to compensate them for the risk of lending to your company.

More specifically, cost of debt measures the minimum rate of return that debt holders require to accept the liability of providing financing to your business. It reflects both the default risk of your company and current market interest rates.

Why should you be measuring and monitoring your cost of debt? There are multiple reasons:

Strategic decision-making — Your cost of debt tells you whether borrowing makes economic sense. If an investment will return 10% but your cost of debt is 12%, you’re destroying value by borrowing to fund it.
Benchmark for evaluation — It provides a baseline for comparing financing offers. That 15% APR might sound high in isolation, but if your current cost of debt is 18%, it’s actually an improvement.
Cash flow planning — Understanding your true debt costs helps you project cash flow accurately and avoid over-leveraging.
WACC component — Cost of debt is a critical input for calculating your weighted average cost of capital (WACC), which companies use to evaluate investment opportunities and business valuation.

Here’s a crucial distinction: your cost of debt is NOT simply the stated interest rate on a single loan.

If you have multiple loans—and most businesses do—your cost of debt is the weighted average rate across all of them. A mix of a 5% term loan and a 12% line of credit will land somewhere in between, depending on how much you owe on each.

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The Two Types of Cost of Debt

There are two ways to calculate cost of debt, and understanding both matters:

Pre-Tax Cost of Debt: This is the raw, unadjusted effective interest rate you’re paying across all your debts before considering any tax benefits. It’s sometimes called your effective interest rate or weighted average interest rate.

After-Tax Cost of Debt: This is the more important number for decision-making. Because interest payments are tax-deductible, they create a “tax shield” that reduces your actual cost. The after-tax cost of debt reflects what you’re truly paying after accounting for tax savings.

Most financial professionals focus on the after-tax cost of debt because it represents the real economic burden on your business.

How to Calculate Pre-Tax Cost of Debt

Let’s start with the simpler calculation: pre-tax cost of debt.

The formula:

Pre-Tax Cost of Debt = Total Annual Interest Expense ÷ Total Debt

This gives you the weighted average interest rate across all your borrowings.

Here’s a real-world example. Let’s say your business has three debt obligations:

Term loan: $125,000 at 6% annual interest rate
Business credit card: $7,000 at 23% annual interest rate
Line of credit: $4,000 at 33% annual interest rate

Calculate interest expense for each:

Term loan: $125,000 × 0.06 = $7,500
Credit card: $7,000 × 0.23 = $1,610
Line of credit: $4,000 × 0.33 = $1,320

Total annual interest expense: $7,500 + $1,610 + $1,320 = $10,430

Total debt: $125,000 + $7,000 + $4,000 = $136,000

Pre-tax cost of debt: $10,430 ÷ $136,000 = 0.0767 = 7.67%

Even though your individual loan rates range from 6% to 33%, your overall pre-tax cost of debt is 7.67% because most of your debt is at the lower rate.

How to Calculate After-Tax Cost of Debt

Now for the more important calculation that accounts for tax benefits.

The formula:

After-Tax Cost of Debt = Pre-Tax Cost of Debt × (1 – Tax Rate)

Or, if calculating directly:

After-Tax Cost of Debt = (Total Interest Expense ÷ Total Debt) × (1 – Tax Rate)

A side-note: Why do taxes matter in debt calculations? Interest payments on business debt are tax-deductible, meaning they reduce your taxable income. This creates what’s called a “tax shield”—you’re effectively getting a discount on your interest payments equal to your tax rate.

Think of it this way: if you pay $10,000 in interest and your tax rate is 21%, you save $2,100 in taxes. Your real cost is only $7,900, not $10,000.

Continuing our example in the previous section:

Pre-tax cost of debt: 7.67%
Corporate tax rate: 21%
After-tax cost of debt = 7.67% × (1 – 0.21) = 7.67% × 0.79 = 6.06%

Your true economic cost of debt is 6.06%, not 7.67%. That 1.61 percentage point difference represents your tax savings!

Using actual dollars:

Annual interest expense: $10,430
After-tax rate: $8,240 ÷ $136,000 = 6.06%
Tax savings: $10,430 × 0.21 = $2,190
After-tax cost: $10,430 – $2,190 = $8,240

Let me walk you through a slightly more complex scenario to solidify your understanding… Say a dental office has the following debt:

Equipment loan: $150,000 at 6.5% annual interest
Line of credit: $50,000 at 8.75% annual interest

Step 1: Calculate interest expense for each loan.

Equipment loan: $150,000 × 0.065 = $9,750
Line of credit: $50,000 × 0.0875 = $4,375

Total interest: $9,750 + $4,375 = $14,125

Step 2: Calculate total debt.

Total debt: $150,000 + $50,000 = $200,000

Step 3: Calculate pre-tax cost of debt.

Pre-tax cost of debt: $14,125 ÷ $200,000 = 0.0706 = 7.06%

Step 4: Calculate after-tax cost (assuming 21% tax rate).

After-tax cost of debt: 7.06% × (1 – 0.21) = 7.06% × 0.79 = 5.58%

Thus, the dental office’s true economic cost of debt is 5.58% after accounting for tax deductions.

Advanced Calculation Methods for Larger Companies

For more sophisticated businesses or those with publicly traded debt, additional calculation methods exist.

Yield to Maturity (YTM) Method

For companies with bonds trading in public markets, the yield to maturity provides the most accurate cost of debt calculation. YTM represents the total return anticipated on a bond if held until maturity, accounting for current market price, coupon payments, and time to maturity.

This method is particularly relevant for publicly traded companies but less applicable to most small and medium-sized businesses.

Credit Rating Method

If your company has a credit rating from agencies like S&P, Moody’s, or Fitch, you can estimate cost of debt by:

Identifying your credit rating
Finding the current market yield for bonds with similar ratings and maturity
Adding a default spread to the risk-free rate (typically U.S. Treasury yields)

Formula: Cost of Debt = Risk-Free Rate + Default Spread

This approach works well for private companies without publicly traded debt.

Synthetic Rating Method

For companies without formal credit ratings, Professor Aswath Damodaran developed the synthetic rating approach, which estimates a company’s implied credit rating based on financial ratios like interest coverage (EBIT ÷ Interest Expense), then applies the corresponding default spread.

Common Mistakes in Cost of Debt Calculations

Avoid these errors when calculating your cost of debt —

Using Nominal Rates Instead of Effective Rates: Your loan agreement might state 8%, but if there are origination fees, monthly service fees, or prepayment penalties, your effective cost is higher. Always calculate using total costs, not just stated interest rates.

Ignoring the Tax Shield: Calculating only the pre-tax cost of debt overstates your actual expense. The after-tax number is what matters for decision-making.

Not Updating Regularly: Your cost of debt changes as you take on new loans, pay off existing ones, or rates adjust on variable-rate debt. Recalculate at least annually, or whenever your debt structure changes significantly.

Treating All Debt the Same: A $10,000 merchant cash advance at 80% APR has a vastly different impact than a $100,000 term loan at 7%. Weight your calculations by the amount of each debt type.

Forgetting Variable Rates: If you have variable-rate debt, your cost of debt fluctuates with market rates. Model different scenarios to understand your exposure.

What Factors Determine Your Cost of Debt?

Understanding the different factors that influence your cost of debt helps you manage it strategically.

Credit Score and Rating

The stronger your credit profile, the lower your cost of debt. Credit ratings from agencies assess your ability to repay obligations. Higher ratings indicate lower risk, leading to reduced interest rates.

For example, a company with an AAA credit rating might secure loans at 3%, while a company with a BB rating could face rates of 7% or higher.

Business Financial Health

Lenders examine:

Revenue trends and stability
Profitability and cash flow generation
Debt-to-income ratios
Asset quality and liquidity
Time in business

Stronger financials translate directly to lower borrowing costs.

Collateral and Security

Secured loans backed by assets like property or equipment typically have lower rates than unsecured loans. According to 2025 data, secured SME loans start around 4-6%, while unsecured loans range from 6-15%.

Market Interest Rates

When central banks raise interest rates, lenders tend to follow suit. The broader interest rate environment significantly impacts your cost of debt, though fixed-rate loans protect you from these fluctuations.

Loan Type and Structure

Different financing types carry different costs:

Term loans: Generally lowest rates (6-12% for qualified borrowers)
Lines of credit: Moderate rates (7-20%)
Equipment financing: Low-to-moderate rates (8-20%) due to collateral
Business credit cards: Higher rates (15-25%)
Merchant cash advances: Extremely high effective rates (35-300%+)

Industry and Business Model

Some industries are perceived as higher risk than others. Restaurants, for instance, often face higher borrowing costs than established professional service firms due to higher failure rates.

How to Use Cost of Debt in Decision-Making

Calculating your cost of debt is only valuable if you actually use it to make better decisions.

Investment ROI Comparison

Before taking on debt to fund an investment, compare the expected return to your after-tax cost of debt.

Say you’re considering new equipment that will increase revenues by 8% annually. Should you finance it with debt?

After-tax cost of debt: 6%
Expected return: 8%
Decision: Yes, the investment return (8%) exceeds the cost of capital (6%), creating value

Conversely, if the equipment only returns 5%, borrowing at 6% destroys value—you’d be better off not making the investment.

Evaluating New Financing Offers

When shopping for loans, convert all offers to after-tax cost using your tax rate, then compare.

Suppose you have two offers: (A) 10% interest, unsecured (B) 8% interest, requires collateral

At a 21% tax rate,

Option A after-tax cost: 10% × 0.79 = 7.9%

Option B after-tax cost: 8% × 0.79 = 6.32%

Option B’s lower rate saves you 1.58 percentage points annually—on a $100,000 loan, that’s $1,580 per year.

Capital Structure Optimization

Your cost of debt helps determine optimal capital structure. As you increase debt levels, your cost of debt typically increases (higher leverage = higher risk for lenders). Finding the balance that minimizes your overall weighted average cost of capital (WACC) maximizes business value.

Refinancing Decisions

Monitor your cost of debt annually. If market rates drop significantly or your credit profile improves, refinancing can reduce costs.

For example, if your current cost of debt is 9%, but improved business performance qualifies you for 6.5% financing, then on $200,000 of debt, refinancing saves you $5,000 annually pre-tax (or about $3,950 after tax).

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How to Lower Your Cost of Debt

Reducing your cost of debt directly improves profitability. Here are a few ways to go about it:

Improve Your Credit Score

Both personal and business credit scores significantly impact borrowing costs. Improve them by:

Paying all bills on time
Reducing credit utilization below 30%
Establishing trade lines with vendors that report to credit bureaus
Disputing any credit report errors
Building longer positive payment history

Strengthen Financial Performance

Lenders offer better rates to businesses demonstrating:

Revenue growth (year-over-year increases)
Strong cash flow generation
Improving profit margins
Healthy balance sheets with adequate working capital

Provide Collateral

Secured loans consistently carry lower rates than unsecured financing. If you have assets like equipment, inventory, or real estate, using them as collateral can reduce rates by 2-4 percentage points.

Shop Multiple Lenders

Different lenders have different risk appetites and pricing models. This is where working with finance brokers (wink, wink) provides enormous value—access to dozens of different lenders means finding the most competitive rates for your specific profile.

Negotiate Terms

Don’t accept the first offer. Ask about:

Rate reductions for auto-pay enrollment
Relationship pricing (discounts for maintaining deposit accounts)
Volume discounts for larger loan amounts
Prepayment flexibility without penalties

Consider Refinancing

When market rates drop or your business strengthens, refinance existing debt. Even a 1-2 percentage point reduction creates substantial savings over time.

Work With Finance Brokers

We at QualiFi can find you lower-cost debt than almost any other lender, almost every time, by:

Matching your profile to appropriate lenders
Leveraging our existing relationships for preferential pricing
Comparing 75+ lender options simultaneously
Negotiating better terms than SMBs can access directly

According to industry data, brokers often secure rates 2-5 percentage points lower than business owners obtain independently, simply through better lender matching and relationship leverage.

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Cost of Debt vs. Cost of Equity

Understanding how the cost of debt compares to the cost of equity provides broader financial context.

Cost of debt

represents returns required by lenders
is easier to calculate (defined in loan agreements)
is tax-deductible (creates a tax shield)
involves fixed or predictable payments
offers lower risk for lenders = lower cost for the borrower
doesn’t dilute ownership

Cost of equity

represents returns expected by investors/shareholders
is more complex to calculate (often uses Capital Asset Pricing Model)
isn’t tax-deductible
involves variable returns (dividends, appreciation)
offers higher risk for financers = higher cost for the borrower
dilutes ownership when issuing new equity

For most small businesses, debt is cheaper than equity when factoring in the tax shield. However, too much debt increases financial risk and can ultimately raise your cost of debt as lenders perceive greater default risk.

Creating Value Out of Debt

Cost of debt is one of the most important financial metrics for your business. It determines whether borrowing creates or destroys value, helps you evaluate financing offers accurately, and provides insight into your overall financial health.

Key takeaways:

Calculate both pre-tax and after-tax cost of debt. The after-tax number is what truly matters for decision-making.
Recalculate your cost of debt whenever you take on new debt, pay off loans, or rates change—at least annually.
Use debt strategically. Compare investment returns to cost of debt before borrowing, and evaluate all financing offers on an after-tax basis
Work to lower your cost of debt—improve your credit score, strengthen financials, and work with finance brokers to access better rates.
A “good” cost of debt depends on your industry and creditworthiness..

Your cost of debt isn’t just a number on a spreadsheet—it’s a tool for making smarter financial decisions that protect profitability and support sustainable growth.

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Frequently Asked Questions (FAQs)

What’s the difference between pre-tax and after-tax cost of debt?

Pre-tax cost of debt is the weighted average interest rate you pay across all loans before tax benefits. After-tax cost of debt accounts for the tax deduction on interest payments, showing your true economic cost. Calculate after-tax by multiplying pre-tax cost by (1 – tax rate). Most financial decisions should use the after-tax number since it reflects actual cash impact.

How often should I calculate my cost of debt?

Recalculate whenever you take on new debt, pay off existing loans, or your interest rates change (particularly important for variable-rate debt). At minimum, review annually as part of financial planning. If you’re actively managing debt or considering new financing, quarterly reviews help you track trends and identify refinancing opportunities.

What’s considered a "good" cost of debt for small businesses?

It varies by industry, creditworthiness, and loan type. In 2025, secured SME loans start around 4-6%, while unsecured loans range from 6-15%. Strong businesses with excellent credit might achieve 5-8% overall cost of debt, while businesses with challenged credit might see 12-18%. Compare your cost of debt to industry peers and traditional bank rates (typically 6-12% for qualified borrowers).

Does my personal credit score affect my business’s cost of debt?

Yes, especially for small businesses. Most lenders require personal guarantees and consider personal credit scores alongside business credit. Traditional banks like Wells Fargo typically require personal FICO scores of 680+ for best rates. Improving personal credit by paying bills on time and reducing credit utilization can lower your business’s cost of debt by 2-5 percentage points, potentially saving thousands of dollars.

How does my cost of debt impact business valuation?

Cost of debt is a key component of weighted average cost of capital (WACC), which investors and buyers use to value businesses. Lower cost of debt reduces WACC, potentially increasing your business’s value. It also signals financial health—businesses securing low-cost debt demonstrate strong credit, stable operations, and lender confidence. When selling your business or seeking investors, presenting a favorable cost of debt strengthens your financial positioning and may improve valuation multiples.

Should I prioritize lowering my cost of debt or paying off debt faster?

Both strategies have merit depending on your situation. If your after-tax cost of debt exceeds investment returns you can achieve elsewhere, prioritize payoff. If your after-tax cost is low (under 6-7%) and you can invest cash at higher returns, maintain the debt and invest excess cash. Aim to pay off highest-rate debt first (credit cards, MCAs) while maintaining lower-rate debt (secured term loans). Work with finance brokers such as QualiFi to refinance expensive debt into lower-cost options before accelerating payoff.