How to Calculate After-Tax Cost of Debt

Tax deductions for debt can make borrowing money less expensive.

The after-tax cost of debt refers to how much money debt really costs after taking into consideration the tax benefits offered for certain types of debt. For example, the Internal Revenue Service allows you to deduct mortgage interest as a deduction, and investment interest can be used to offset your investment income. These tax deductions reduce the cost of the debt. To determine how much the debt truly costs, you need to know which tax bracket you're in and how much interest you can deduct.

Things You'll Need

• Calculator
• Tax tables (see Resources)

Instructions

1. Use the tax tables to determine which tax bracket you fall into. For example, if you are single and your adjusted gross income equals $150,000, you fall in the 28 percent tax bracket for 2010.

2. Determine the amount of interest you deducted on your taxes. You can check your itemized deductions to find out the amount of interest you deducted from either your mortgage or investment debt.

3. Divide the tax bracket you fall into by 100 to convert it from a percentage to a decimal. In this example, you would divide 28 percent by 100 to get 0.28.

4. Subtract the result from Step 3 from 1. In this example, you would subtract 0.28 from 1 to get 0.72.

5. Multiply the result from Step 4 by the amount of interest you deducted from your taxes from Step 2 to calculate the after-tax cost of debt. Completing the example, if you paid $10,000 in interest, you would multiply 10,000 times 0.72 to find that the after-tax cost of the interest was $7,200.

References

• IRS: Publication 936
• Bankrate: An Interest-ing Investment Deduction
• Investopedia: Cost of Debt

Resources

• The Tax Foundation: Federal Income Tax Tables