Interest Cost

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.

KEY TAKEAWAYS

 Interest cost is the amount of interest a borrower pays over the life of the
debt. 
 Negative points and rebates should be subtracted from interest costs. 
 Interest costs are only one factor in a loan analysis, other things to
consider include opportunity costs, tax benefits, and closing costs, among
others. 
 Certain types of interest can have tax benefits, such as mortgage and
student loan 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),1 2  and for corporations, interest payments on debts such as loans and
bonds.