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What Is Interest Rate on Debt?

Helen Akers
Helen Akers

Interest rate on debt is the cost of borrowing funds from outside sources. When a company issues debt in the form of bonds, the interest rate on debt is referred to as the cost of capital. It is the price that a company pays for funding its operations, often on a large scale. From an investor's perspective, the interest is the rate of return he can expect to receive for loaning the company money.

Consumer borrowers often see the interest rate on debt come in the form of credit card interest rates or mortgage loan rates. In addition to paying back the principal amount, a borrower typically reimburses the lender for the risk taken in lending funds. The interest rate represents a combination of market and individual risk that the funds will not be paid back in full. An interest rate on debt helps shield lenders from some of that risk by reimbursing them with an additional amount prior to the loan's maturity date.

Man climbing a rope
Man climbing a rope

The actual paid interest rate on debt may in fact be zero. This type of scenario occurs when a consumer borrows funds to pay for a purchase but then repays the lender in full within a grace period. An example would be an individual who charges purchases on a credit card with a zero balance and pays the new balance in full by the next billing statement due date. Most banks do not start charging interest until the statement due date has passed.

With larger consumer purchases, such as a house or a car, a portion of the monthly payment usually goes towards interest charges while the remainder is applied against the principal value of the loan. The total cost of borrowing for the consumer would be the sum of all the interest payments made over the life of the loan. If a borrower pays more than the minimum monthly payment or pays off the loan balance prior to its maturity, his total cost of borrowing will be reduced.

Companies also issue debt in the form of bonds to investors in order to receive cash to finance capital projects or continue normal operations. The cost of issuing that debt is the company's cost of capital and is paid out in bond interest payments. Bonds are typically purchased for an initial value which may be lower, higher, or the same as its face value. When the bond matures, the investor is owed the face value of the bond, which is also comprised of interest payments.

The value of the bond may be higher or equal to its face value. If the interest rate or cost of capital is high, then the risk of that company not being able to pay back its debt is also high. Some bonds pay a zero coupon rate, which means that the investor recoups only the promised face value of the bond at maturity.

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