Many say interest is the lubricant that makes that modern financial world go around, and interest expense influences decisions from the grocery aisle to the boardroom. Borrowing money in most cases is not free, and being able to manage the added cost of repaying debt and interest must be managed properly to avoid financial strain. Let's break down why interest expense is important and how to manage it correctly.
Understanding interest expense
Interest expense is the cost of borrowing money, whether for a business loan, mortgage, credit card, or bond. It represents the price paid to lenders in exchange for capital. The total interest expense depends on three factors: the loan amount (principal), the interest rate, and the duration of the loan.
For example, if a business takes out a $500,000 loan at a 5% annual interest rate, the yearly interest expense would be $25,000. Managing these costs is important for both businesses and individuals, as excessive interest payments can put a strain on cash flow, profitability, and general human well-being.
Why interest expense matters
Interest expense impacts profitability and cash flow
Interest expense has a direct impact on the bottom line, and a company with high-interest payments will see reduced net income, meaning less profitability. People can also find it difficult to manage when interest expenses increase, which is why when the Federal Reserve raises interest rates, everyday purchases using credit are much more expensive and difficult to pay off. For instance, someone carrying a $15,000 credit card balance at 22% annual percentage rate (APR) will pay $3,300 annually in interest alone, making it harder to pay off the principal if rates rise.
Interest expense can have tax deduction advantages
Many businesses can deduct interest expenses on loans used for operations, reducing taxable income. Homeowners with mortgages may also deduct interest, lowering their overall tax burden, although personal credit card interest is not deductible.
Economic impact
At Federal Reserve board meetings, consumers and businesses from all over the world anxiously await to hear the direction that the Fed will take with interest rates. Interest expenses will fluctuate with interest rates, which will fluctuate with economic conditions. When central banks raise interest rates, borrowing becomes more expensive, leading to higher interest costs for businesses and consumers. Conversely, in low-rate environments, borrowing is cheaper, often encouraging investment and spending. This can sometimes lead to asset bubbles and overinvestment when money is cheap and plentiful.
How to manage interest expense
One of the most effective ways to reduce interest costs is by refinancing high-interest debt. For instance, a homeowner with a 7% mortgage refinancing to 4.5% could save thousands over time. Businesses can also renegotiate their loan terms to secure lower interest rates, improving cash flow and profitability. Another important strategy is prioritizing debt repayment, particularly for high-interest loans like credit card balances. Paying off these debts first helps minimize long-term interest costs and strengthens financial stability in the long term.
Balancing debt with business growth is equally important, and many companies will take on debt to expand, such as financing new store openings or acquiring additional operating equipment. While this can lead to increased revenue growth, excessive interest expenses can strain profits if not managed carefully. A business that borrows too much may struggle to make ends meet and honor preexisting obligations, especially in rising-rate environments. Carefully analyzing borrowing and capability while maintaining a manageable debt load lets companies grow strategically without being weighed down by burdensome interest payments.
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Example: Larry’s Lithium deals with a rise in interest rates
Let's use an example of Larry’s Lithium, a U.S.-based raw lithium refining company, that secured an original loan of $5 million at a 5% interest rate, resulting in an annual interest expense of $250,000. This interest rate was not fixed and instead floated with the Federal Reserve’s base rate. After the Federal Reserve increased interest rates, the loan’s interest rate climbed to 7.5%, pushing the company’s annual interest expense to $375,000.
This 50% rise in interest expense directly affects Larry's Lithium's bottom line, reducing available cash for expansion, equipment upgrades, and other operational improvements that might be sorely needed in the future.
Businesses relying on debt must carefully manage rising borrowing costs to avoid financial strain when interest rates fluctuate and interest expense becomes a much greater liability than may have previously been believed.
