When it comes to securing working capital, established businesses have a broad range of financing options available. Shopify’s new lending options are designed to help merchants find the right financing to grow their businesses:
How do you know which financing option is right for you? A good place to start is determining how much you want to pay to borrow money, known as cost of debt.
What is cost of debt?
Borrowing money isn’t free. Lending capital always comes with the risk that it won’t be repaid. To offset this risk, lenders ask borrowers to offer a share of equity, present collateral, or, most commonly, pay interest. The cost of debt is what you’ll ultimately pay to borrow money.
Cost of debt formula
There are many ways to calculate the cost of debt. One common way is to use annual percent rate, or APR. Using the formula below, you can calculate APR, which is the annual cost of borrowing money, represented as a percentage.
APR = [(Total Interest Paid + Fees / Principal) / Loan Term] * 365 * 100
The calculation includes fees outside of the listed interest rate, which can significantly raise the cost of debt. The simple number makes it easier to compare the total cost of multiple lending offers.
Another way to calculate the cost of debt is to use a business loan calculator. With a calculator, you can see how much a loan will cost you. You can also get an idea of what your monthly payment will look like and how extra payments will impact the interest you pay.
LOAN REPAYMENT TIP: Want to know how much it will cost to take out a loan? Try our free Business Loan Calculator.
How to calculate cost of debt
When it comes to working out the cost of debt, there are several factors to consider, including interest and other types of fees. It’s also important to look at how much a financing option, like Shopify Capital Loans, might cost you before and after taxes. Here’s how tax deductions and a range of different fees can all influence how much borrowing will actually cost you.
4 common fees that affect cost of debt
There are several different charges associated with borrowing money. Here are four of the most common fees:
Interest
Interest refers to how much a lender charges a borrower, and it’s commonly represented as an APR. Interest functions as compensation for a lender taking on the risk to provide a loan. As borrowers make regular repayments, they pay a combination of the principal and interest.
Origination fee
Lenders can charge an origination fee to cover the cost of processing a loan application. This is usually a one-time, upfront fee lenders use to assess a borrower’s eligibility, evaluate the application, and prepare the loan.
Prepayment fee
Some lenders may charge prepayment fees if borrowers pay off all or part of their loans early. This is also called an early repayment fee or prepayment penalty. These fees are in place to ensure borrowers pay back loans over longer time periods, so that lenders can continue to receive interest.
Late payment fee
Lenders can charge borrowers late fees for missing payment deadlines. Late fees encourage timely payments and ensure borrowers make payments according to any agreed-upon repayment schedules.
How to calculate pre-tax cost of debt
Interest counts as a tax deductible expense, so businesses have the opportunity to save if they claim interest. That’s why it’s important to know the difference between what you’ll pay before and after taxes.You can consult your tax adviser to learn more about eligibility requirements.
Let’s start by calculating the pre-tax cost of debt. Say you want to take out a $500,000 loan and you are charged $35,000 of interest expense over a one-year term. There is also a $25,000 origination fee.
Here’s how you would calculate the annual percentage rate:
[($35,000 + $25,000 / $500,000) / 365] * 365 * 100 = 12%
You’ll notice that on top of the $35,000 in interest you’ll pay over the lifetime of the loan, the origination fee increases the APR to 12%.
How to calculate after-tax cost of debt
Pre-tax cost of debt can give you a simple idea of how much one financing option is going to cost. But it doesn’t factor in any tax savings you might see from deducting interest. To find your after-tax cost of debt, we’ll use this formula:
Interest Rate * (1 – Effective Tax Rate) = After-Tax Cost of Debt
So, for our $500,000 loan at 7% interest with a 12% effective business tax rate, you would get:
.07 * (1 – .12) = .061
That leaves you with an after-tax cost of debt of just over 6%, which means you ultimately would save money by claiming interest on your taxes.
How to calculate cost of funds for Shopify Capital Loans
Let’s say you’re a Shopify merchant who is eligible for financing through a Shopify Capital Loan. You’ll want to understand how much that loan would cost you, if you’re approved for financing. Shopify expresses cost of debt for loans as a flat dollar amount, which is calculated as a percentage of the principal loan amount. Shopify calls this flat dollar amount the cost of funds. You can translate cost of funds into an APR using this formula:
Shopify Capital Loans APR = [Cost of Funds / Principal) / Loan Term] * 365 * 100
How to evaluate which financing option will lower your cost of debt
Cost of debt is helpful for comparing similar financing options, but it’s also helpful to understand how different types of financing options can help your business. Through Shopify Lending, there are two lending options designed to help larger retailers improve cash flow, optimize costs, and invest in future success.
Shopify Capital Loans and Cash Advances
Benefits of capital loans and cash advances
When your business needs a one-time injection of capital to help it grow, there’s Shopify Capital Loans and Cash Advances. If you’re an eligible merchant, you will receive a customized financing offer in your Shopify admin. From there, you can apply online in just a few clicks. If approved, funds will be deposited in your linked bank account in as soon as two days. Payments are made automatically as a percentage of your daily sales, and you always have full control over your business, with no equity stake taken—ever. Shopify Capital merchants enjoy ease of use and peace of mind that they’re repaying financing as they grow.*
Examples of how businesses use capital loans and cash advances
Larger retailers use capital loans and cash advances to make big, one-time investments into their operations to help them grow. Loans usually have payback periods of more than six months. Shopify merchants can and do use Capital for any business use case. Large retailers often invest in initiatives like launching new products, expanding into new markets, or making large new purchases of stock, inventory, and supplies to ramp up production.
Types of businesses that choose capital loans and cash advances
High-growth businesses wanting to increase predictable cash flow can use loans and cash advances to make large investments and realize their potential. This capital is the catalyst to get the engine going, to help your businesses scale easily.
Shopify Line of Credit
Benefits of line of credit
Running a business can be unpredictable. Shopify Line of Credit gives you the peace of mind to stay ahead of frequently changing businesses needs. It also gives you the flexibility to access large amounts of funds when needed, without the fees and higher interest rates of credit cards. Once approved, you can typically access funds faster than through a more traditional loan.
Examples of how businesses use lines of credit
An established business will use a line of credit to deal with unexpected expenses, like restocking a surprise bestseller or extending a marketing campaign. Lines of credit are also commonly used to cover short-term expenses like shipping costs and supplies, usually in durations of less than six months. Some businesses even use lines of credit to make investments like launching their first physical retail location or developing a new product.
Types of businesses that choose lines of credit
It’s common for large businesses at all stages to use lines of credit to boost their cash flow to cover short-term and unexpected expenses. It’s similar to how a consumer might use a credit card.
Use cost of debt and cash flow to help choose the right financing option
When you’re looking at securing financing for your business, you can look at the cost of debt and how the repayments are structured to match your business’s goals and cash flow.
Whether you’re looking for an injection of capital to kickstart your business, optimize your operation, or just give you the flexibility to adapt to an ever-changing market, Shopify Lending offers multiple options to meet the needs of established, scaling businesses.
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Cost of debt FAQ
Is cost of debt higher than equity?
Typically, the cost of debt will always be lower than the cost of equity. This is due to the fact that interest on a loan can be tax-deductible, and shareholder expectations on returns are much higher compared to lenders.
What is an example of cost of debt?
The cost of debt is what you pay to borrow money. A common example is annual percentage rate, which is calculated using a loan’s interest rate and fees associated with taking out that loan.
What is the difference between cost of debt and WACC?
It’s common for businesses to use a combination of debt and equity to finance their operations. Weighted average cost of capital, or WACC, uses cost of debt and cost of equity to help businesses calculate an average cost for financing their operations. In other words, cost of debt is just one component of WACC.
*Shopify Capital loans must be paid back within 18 months, and minimum payments apply at 6 and 12 months. Merchants must pay a minimum of 30% of the Total Payment Amount within 6 months of receiving funding and an additional 30% within 12 months of receiving funding.
This article is focused on industry standards and descriptions are not specific to Shopify's financial suite of products. To understand the features of Shopify's lending products, please visit shopify.com/lending.
Available in select countries. Offers to apply do not guarantee financing. All financing through Shopify Lending, including Shopify Capital and Line of Credit products, is issued by WebBank in the United States.