Interest Cost: What it Means, How it Works

What Is Interest Cost?

Interest cost is the cumulative amount of interest a borrower pays on a debt obligation over the life of the borrowing. Interest is paid on the debt in addition to repayment of principal. However, any negative points or rebates a lender pays to a borrower should be subtracted from the interest cost as they are in effect a refund of future interest. In consumer mortgage loans, this amount should include any points paid to reduce the interest rate on a loan, since points are in effect pre-paid interest.

Understanding Interest Cost

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.

Special Considerations 

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, such as the London Interbank Offered Rate (LIBOR).

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.

Interest Cost vs. Taxes

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), and for corporations, interest payments on debts such as loans and bonds.