When you borrow money for your business, you pay interest. That interest represents the cost of using someone else’s money to grow. And just like you’d compare prices before buying equipment or stock, you should understand what your debt really costs you.
The cost of debt is important to understand because it affects everything from your monthly cash flow to your long-term growth plans. But unlike the interest rate quoted by your lender, the true cost of debt includes taxes, fees and the type of loan you choose. Get it right and you could save money, avoid surprises and make better funding decisions.
In this article we’ll explain the cost of debt formula in easy-to-follow steps, including how to calculate it for your business, why it changes over time and how to keep it as low as possible.
In a nutshell: The cost of debt is the effective interest rate you pay on loans, taking into account taxes and fees. Calculating it helps you compare funding options, plan for growth and avoid overpaying – ultimately helping you borrow with confidence.
What is the cost of debt?
The cost of debt is the effective interest rate your business pays on its borrowing. This includes loans, credit lines and any other debt used to fund operations or growth.
There are different ways to think about the cost of debt:
Before tax: This is the nominal interest rate you pay on your debt, such as 6% on a £100,000 loan.
After tax: Because interest payments are usually tax-deductible, the actual cost to your business is likely lower than the stated rate. For example, if your tax rate is 20%, a 6% loan would actually cost you 4.8% after taxes (6 * (1 - 0.20)).
If you have multiple loans, your cost of debt is the weighted average rate across all of them. For example, a mix of a 5% term loan and a 12% overdraft will land somewhere in between, depending on how much you owe on each.
In October 2025, the average interest rate for new SME bank loans in the UK was 5.82%. But rates can vary widely depending on your creditworthiness and the lender.
The cost of debt might feel like an abstract number but it’s a real expense that affects your profitability. The lower you can keep it, the more money stays in your business to reinvest or take home.
Why is the cost of debt important?
The cost of debt is important because it directly impacts your bottom line. Every pound you spend on interest is a pound you can’t reinvest in your business. And if your debt costs too much, it can put pressure on your cash flow and limit your ability to grow.
For new businesses, understanding the cost of debt could help you avoid taking on debt you can’t afford. When you’re early on in your business journey, you’re most likely to be focused on survival. So knowing the true cost of a loan can help you decide whether to borrow now or wait until your revenue is steadier.
For more established businesses, the cost of debt is a very important part of your financial strategy. It helps you compare funding options, plan for expansions and even negotiate better terms with lenders. In 2024, UK SMEs borrowed £62.1 billion in new loans, showing just how much businesses rely on debt to fund their operations. And with borrowing costs rising, it’s more important than ever to get the most competitive deal possible.
Plus, if you’re planning for long-term growth, the cost of debt affects how much you can invest in new equipment, staff, or marketing. The lower the cost of debt is, the more money you’ll have left over to fuel your ambitions.
What is the cost of debt formula?
Pre-tax cost of debt formula
The simplest way to calculate cost of debt is to divide your total annual interest by your total debt.
Pre-tax cost of debt = (total interest expense / total debt) * 100
For example, if your business pays £5,000 in interest on a £100,000 loan, your pre-tax cost of debt is 5%.
Total interest expense includes all the interest you pay on loans, credit cards and overdrafts in a year. You should be able to find this number on your income statement or loan statements.
Total debt is the sum of all your outstanding loans and credit lines. If you’re not sure what yours is, check your balance sheet or ask your accountant.
After-tax cost of debt formula
The pre-tax cost of debt is what you pay before accounting for tax relief. But because interest payments are tax-deductible in the UK, the after-tax cost is usually lower.
The after-tax cost of debt calculation uses this formula:
After-tax cost of debt = pre-tax cost of debt * (1 - your tax rate)
For example, if your pre-tax cost of debt is 5% and your tax rate is 20%, your after-tax cost of debt would be 5% * (1 - 0.20) = 5% * 0.80 = 4%.
This tax benefit is called the ‘tax shield,’ and it’s one of the biggest advantages of debt over other types of funding. For example, if you borrow £100,000 at 6% interest, you’ll pay £6,000 in interest each year. But if your tax rate is 19%, you’ll save £1,140 in tax, bringing your net cost down to £4,860 (or 4.86%).
This is why businesses often prefer debt over equity financing. Debt is usually cheaper and the interest is tax-deductible. Equity, on the other hand, doesn’t come with tax breaks and can cost more in the long run.
Calculating the cost of debt for multiple loans
Most UK small businesses have a mix of debt (eg a term loan, a credit card and an overdraft). You can find your overall cost of debt by calculating a weighted average.
List all your loans, their balances and their interest rates
Multiply each loan balance by its interest rate to find the annual interest
Add up all the interest payments and all the loan balances
Divide the total interest by the total debt
For example, if you have:
£50,000 loan at 6% = £3,000 interest
£30,000 loan at 8% = £2,400 interest
£20,000 overdraft at 10% = £2,000 interest
Your total interest would be £7,400 and your total debt would be £100,000. So your weighted average cost of debt is 7.4% (£100,000 / £7,400 = 7.4%).
The weighted average gives you a clearer picture of what your debt is really costing you. And if one of your loans has a much higher rate, you can prioritise paying it off first.
What factors influence your cost of debt?
Your cost of debt depends on several factors, some of which you can control and others you can’t.
Credit score: Lenders offer lower rates to businesses with stronger credit histories. If your score’s low, you’ll likely pay more. You can improve it by paying bills on time and keeping your debt levels manageable. Tide’s Credit Score Insights can help you track and boost your score.
Loan type: Secured loans (backed by assets like property or equipment) usually have lower rates than unsecured loans. In 2025, secured SME loans in the UK start at around 4-6%, while unsecured loans can range from 6-15% or more.
Economic conditions: When the Bank of England raises interest rates, lenders tend to follow suit.
Lender terms: Banks, online lenders and government-backed schemes all offer different rates. So shopping around could save you thousands.
Loan term: Longer loans tend to have higher rates but lower monthly payments. Shorter loans tend to cost less in interest but require bigger repayments.
How is the cost of debt used in financial decisions?
Once you determine the cost of debt, you can use it to help you make smarter financial choices.
Comparing funding options: If you’re comparing a business line of credit vs a business overdraft, calculating the cost of each could help you pick the cheaper option.
Planning for growth: If you’re considering a big investment, like new equipment or a second location, the cost of debt can inform whether borrowing makes sense. If the return on your investment is higher than your cost of debt, it could be a smart move.
Managing cash flow: High debt costs can eat into your profits. For example, if your after-tax cost of debt is 5% but your profit margin is 10%, you’re still coming out ahead. But if your margin is only 6%, you might be better off waiting.
Negotiating with lenders: If you know your current cost of debt, you could try pushing for better rates. And if you’re applying for a new loan, you could use it to compare offers.
The cost of debt is also a key part of your Weighted Average Cost of Capital (WACC), which combines the cost of debt and equity to show your overall cost of funding.
Cost of debt vs cost of equity
Debt and equity are the two main ways to fund your business. But they work very differently.
Debt is money you borrow and pay back with interest. The cost is usually lower and the interest is tax-deductible. But you have to make regular payments and you risk defaulting if you can’t keep up.
Equity is money you raise by selling shares in your business. There’s no interest to pay, but you give up a portion of your profits and control. The cost of equity is usually higher, as investors typically expect a return of 10-20% or more, compared to 4-15% for debt.
For most small businesses, debt is the cheaper option. But if you’re growing fast and need more capital than you can borrow, equity might be the way to go. To learn more about how the cost of equity works and how to calculate it, read Understanding the cost of equity formula.
How can you reduce your cost of debt?
Reducing your cost of debt can save you money and free up cash flow for growth, and there are lots of ways to do it.
Improve your credit score: Pay bills on time, reduce your existing debt and avoid late payments.
Choose the right type of loan: Secured loans and government-backed schemes like the Growth Guarantee Scheme often have lower rates.
Refinance high-interest debt: If you have an expensive loan, see if you can switch to a cheaper one (just make sure the fees don’t outweigh the savings).
Negotiate with lenders: If you’ve been a reliable customer, your bank might offer you a better rate so it could be worth asking.
Use tax breaks: Make sure you’re claiming all the tax relief you’re entitled to – the less tax you pay on your interest, the lower your after-tax cost.
Pay off expensive debt first: If you have multiple loans, focus on the ones with the highest rates (this is called the ‘avalanche method,’) to potentially save hundreds or even thousands in interest.
Wrapping up
Understanding how to calculate the cost of debt helps you compare loans, plan for growth and avoid overpaying.
Here’s a reminder of the key points:
The cost of debt is the effective interest rate you pay on loans and can be worked out before or after accounting for taxes
Calculate it by dividing your annual interest by total debt, then adjust for taxes
A lower cost of debt means more money to reinvest in your business
You can compare loans using the weighted average cost for multiple debts
Improve your rate by boosting your credit score, refinancing, or negotiating with lenders
Ready to explore your options? Compare Tide’s business loans from over 80 lenders to find the right funding for your needs. You could borrow up to £20 million for your business, and we’ll provide expert help to guide you through the application process.
FAQs
Why is the after-tax cost of debt lower than pre-tax?
Because interest payments are tax-deductible in the UK. Multiply your pre-tax cost by (1 - your tax rate) to find the after-tax cost. For example, with a 19% corporation tax rate, a 5% pre-tax cost would become 4.05% after tax (5% * (1 - 0.19) = 4.05%).
How do I find my business’s effective tax rate?
Your effective tax rate is the percentage of your profits you pay in tax. You can find it on your tax return or ask your accountant. For most small businesses, it’s 19-25%.
Can I use the cost of debt formula for personal loans?
Yes, the formula works the same way. But personal loans aren’t tax-deductible, so there’s no after-tax cost to calculate.
How often should I recalculate my cost of debt?
Consider recalculating it whenever you take on new debt, pay off a loan, or your interest rates change. Aim to review it at least once a year as part of your financial planning.
What’s a good cost of debt for a small business?
It depends on your industry and creditworthiness. In 2025, secured SME loans in the UK start at around 4-6%, while unsecured loans range from 6-15%.
How does inflation affect the cost of debt?
If inflation rises, lenders may increase interest rates to compensate. But if you have a fixed-rate loan, your cost of debt stays the same. Variable-rate loans usually get more expensive.
How does the cost of debt impact my business valuation?
A lower cost of debt will likely increase your business’s value by reducing your funding costs and improving profitability. Investors and buyers will look at this when evaluating your business.
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