Interest_Cost

Key Takeaways

• Interest cost is the total interest paid on a debt over its life.
• Rebates and negative points should be subtracted from the interest cost.
• Interest costs influence other financial factors like opportunity costs and tax benefits.
• Interest rates can be fixed or variable, impacting how interest costs are calculated.
• Home mortgage and student loan interest payments may have tax advantages.

What Is Interest Cost?

Interest cost is the total amount a borrower pays over the life of a loan beyond repaying the principal. Knowing this figure helps borrowers and businesses compare financing options and judge whether borrowing is worth the tradeoff.

Interest cost can change with loan type, rate structure, payment frequency, and the benchmark used to set the rate. It can also be shaped by points, lender credits, tax treatment, and opportunity costs.

How Interest Cost Affects Your Loan Decisions

Interest cost is one measure of a loan’s economics or internal rate of return. However, other measures—such as lender fees and upfront costs including loan closing costs, tax benefits and consequences, principal reduction and opportunity costs in the form of re-investment rates—should also be included in a thorough analysis of the loan choices.

Interest cost comes into play in a variety of consumer financial obligations including mortgage, student and auto loans, and credit cards. Interest cost is also an important consideration for corporate borrowings such as commercial paper, revolving lines of credit and long-term bank loans, bonds, and lease costs are also very much affected by interest cost. Banks also incur interest costs when they credit depositors' interest on their bank accounts.

Factors That Influence Interest Costs

Interest cost may be quoted as an annual percentage rate (APR). But in order to have an accurate understanding of your financial obligation, it is important to understand how lenders calculate the interest that accumulates on your loan. Interest might accrue on a daily or monthly, or quarterly basis. Additionally, some lenders offer loans for which the interest cost is not payable for an initial period but instead is added to the outstanding amount the borrower owes.

Interest cost may be fixed to a reference security, such as the 10-year U.S. Treasury bond, for the life of the loan or floating (also called a variable). The interest cost on debt with rates that adjust periodically is tied by a formula to an interest rate benchmark.

For debt with variable interest rates, lenders often include provisions that provide some measure of protection from extreme fluctuations in interest costs by offering interest rate caps. These usually also contain floors, to assure the lender a minimum acceptable rate of interest.

Tax Implications of Interest Costs

Certain types of interest costs are treated favorably for tax purposes in several jurisdictions. These include interest payments on home mortgage debt and student loan interest payments (both are subject to limitations and exclusions),12 and for corporations, interest payments on debts such as loans and bonds.3