Difference Between Cost of Debt and Interest Rate (With Table)

The financial manager has to keep an eye on the interest rates, inflations, and exchange rates to provide useful information about the financial market to the board members to make competent decisions. Large and small organizations take loans from banks, investors and sell stocks to the shareholder to keep the business running.  The financial division generates a balance sheet, financial statements to review the cost of capital. The terms cost of debt and interest rates play an important role in measuring the cost of capital.

Cost of Debt vs Interest Rate

The difference between the cost of debt and interest rate is that cost of debt is the minimum interest given to the investor or bondholder for investing in the company, and the interest rate is the amount charged on the principal amount by the investor monthly or yearly. The cost of debt depends on the percentage of the interest rate charged on the principal amount.

The cost of debt is the average amount on the debt paid on the loans or bonds taken by the company. The cost of debt is calculated by the financial manager when the company is planning to procure new debt from the investors to guarantee the security of the bonds and show the company’s financial performance to the investors.

The interest rate is the minimum rate paid on the principal amount either, monthly or yearly. The interest rate is paid on the outstanding debts and the new debts. The interest rates changes as per the change in the market condition and the inflation rates, and Banks charge different interest rates for different types of loans.

Comparison Table Between Cost of Debt and Interest Rate

Parameters of ComparisonCost of DebtInterest Rate  
DefinitionThe cost of debt is the overall debt that the company has to pay to the creditors.Interest rate is the percentage of the principal amount charged by the lender of money for using his money.
Declared byThe cost of debt is calculated by the company and distributed among the investors every year.The Interest rate is charged by the investors, banks, and other financial institutes.
Outstanding debtThe cost of debt is not calculated on outstanding debts but new debts.Interest rate calculation includes the outstanding amount, the principal amount, and the period.   
Interest rateThe cost of debt requires a current interest rate as per the demand of investors.The interest rate for a principal amount will be fixed at the time of borrowing. It will not change as per the market condition.
Factors Affecting  Interest rate, long payback period will affect the cost of debt.Credit score, bond length, inflation, loan type, and others.

What is Cost of Debt?

Cost of debt is the yield rate or the return on the investment that is given to the creditor for funding in the company. It is paid annually and given to the investors to ensure that their money is used properly. The cost of debt is one of the components of the cost of capital that is used to measure the company’s financial performance.  The cost of debt is calculated on the current market interest rate and not on the previous interest rate when taking the debt from the same creditor or other creditors.  The cost of debt is the amount before the tax is paid.

The cost of debt for new debt is calculated by dividing the interest expenses by the average interest rate. The true cost of debt is the after-the-tax cost of debt that is obtained by multiplying the yield to maturity with one minus tax rate. Companies usually use the after-the-tax cost of debt to calculate the weighted average cost of capital because the stock price of the company depends on the tax rates. The after the tax cost of debt will help the company to gain the trust of the investors and attract them to invest in the company’s projects.

What is Interest Rate?

Interest rate is the percentage rate that is charged by the bondholder on the principal for using his money. It is either paid annually or monthly. The interest rate differs for different types of loans like business loans, home loans, educational loans, asset loans, government loans, project loans, and others. The company lends money either from financial institutions or outside investors to invest in their business growth or projects.  The investors charge lower interest rates than financial institutes.  The rate of interest rate depends on the type of loan. The interest rate of Short-term loans is less than long-term loans.

The interest rate gets influence by government policies, market conditions, and inflation rates. The interest rates are directly proportional to the inflation rates.  The financial manager has to be updated with the changes in external factors, maintain good relationships with banking institutes, investors to provide effective information to the board members to rain the capital. The financial manager has provided financial statements and cash flow information to the investors and stockholders to attract them to invest in the company.

Main Differences Between Cost of Debt and Interest Rate

  1. Cost of debt is the minimum amount determined on the overall debts of the company that has to be paid to the creditors for raising new debt, whereas interest rate is the percentage rate on the principal amount that has to be paid to the creditor either monthly or yearly.
  2. The cost of debt is calculated and decided by the company, and the interest rate on the bond is decided by the financial institute or investor.
  3. The cost of debt is calculated on the new debt when the company decides to raise the capital, and the outstanding debt is not considered in the calculation, whereas the interest rate calculation includes outstanding debt amount, principal amount, and the period. 
  4. The cost of debt depends on the interest rate and the tax rate, whereas the interest rate is fixed for a bond. 
  5. Factors affecting the cost of debt are interest rate and the period of debt, whereas the interest rate is a credit score, loan type, and inflation rates.

Conclusion

The company has to raise capital to grow the business and to develop new products and services. The financial manager supports the decision-makers in raising the capital by providing information on current interest rates, market conditions, exchange rates, and other influencing factors. The financial manager creates a cost of capital sheets, financial and balance sheets that include the cost of debt that helps the investors to analyze the financial condition of the company and the risks and opportunity of investing in the company.

References

  1. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3197415
  2. https://books.google.com/books?hl=en&lr=&id=9OUXEAAAQBAJ&oi=fnd&pg=PP1&dq=Fundamentals+of+Financial+Management,+Concise+Edition,+8th+ed&ots=CllEwUzbK2&sig=ioKPaQyrcEgl_MXMP7GEqBg5u1E