What cost of capital means
Cost of capital is what it costs you to have the money you lend. If you borrow on a line of credit, it's the interest on the line plus any fees. If investors fund your loans, it's the return you've promised them. If you lend your own cash, it's less visible — but that money could be earning something elsewhere, and many lenders assign it a rate for planning.
Why the spread is the number that matters
Suppose you make a loan at 12% and fund it from a line of credit at 9%. Before fees, your spread is 3%. On a $200,000 loan held for a year, that's roughly $6,000 of interest margin, not $24,000. Points and fees improve the picture; idle cash, unfunded holdback, and defaults hurt it.
Looking at the spread loan by loan shows which deals actually make money and which only look good on the term sheet.
How to calculate it for a loan
For each loan, identify which capital source funded it and the rate on that source. Then, for each day the loan is outstanding, compare the interest the loan earns to the cost of the capital used to fund it. On construction loans, remember that only funded draws use capital, so cost of capital usually follows the drawn balance even when the borrower pays on the full commitment.
- Identify the capital source and its rate for each loan
- Track the amount of capital actually deployed, day by day
- Compare interest and fee income to capital cost over the same period
- Break income into categories: interest, default interest, late fees, and fees
Don't forget idle cash
Capital that sits waiting for the next deal still costs money if it's borrowed or promised to investors. A line of credit that's drawn but not deployed, or investor money raised before you have loans to place, drags down portfolio return. Tracking cash available after reserves and commitments helps you avoid raising or drawing capital earlier than you need it.
Reserves and commitments
Not all cash in the bank is available to lend. Most lenders keep reserves, and approved but unfunded loans — plus undrawn construction holdback — are already spoken for. A realistic view of available cash subtracts both. It's the number you need before saying yes to the next borrower.
When capital sources change
Lenders often move a loan from a credit line to their own capital, or the reverse, as balances and rates change. When that happens, keep the history intact: the cost of capital before the move belongs to the old source, and the cost after belongs to the new one. Rewriting the past makes old reports disagree with themselves.
Reporting it clearly
A simple monthly view — earnings by loan, cost of capital by loan, and the spread — is often enough to change how you price deals. If the books are kept separately, make sure the loan-level numbers reconcile with the income statement, so you and your accountant are looking at the same results.
This guide is general information, not tax or accounting advice. How you record capital costs for tax purposes is a question for your CPA.
Pricing with cost of capital in mind
Once you know your cost of capital by source, pricing gets more deliberate. A short, small loan funded from an expensive line may need more points to be worth doing than a larger loan funded from your own cash. Construction loans with large holdbacks behave differently depending on whether you charge interest on the full commitment or the drawn balance, and whether your capital sits idle while the holdback waits.
Write down a target spread for each capital source and check new deals against it. It turns a gut feeling into a rule you can explain to partners.
PML ties each loan to the capital account or credit line that funded it, shows earnings net of cost of capital per loan and across the portfolio, and keeps history with the original account when capital is reassigned.