After Tax Cost of Debt
What It Means and How to Calculate It

Your after tax cost of debt is the true cost of carrying your debt burden after you calculate the effects of any tax deductions or other write-offs that may apply. Knowing this information should be part of your tax debt solutions.

Certain types of debt, such as a home mortgage loan debt, will allow you to make certain deductions at tax time depending on specific factors that apply to you and your financial situation.

You never truly know with any certainty how much a loan or debt is costing you until you calculate the true after tax cost. Making this calculation gives you a much more accurate picture of where your money is going.

Read on to learn more about the after tax cost of your debt load and how to calculate the true cost.

Calculating the True Cost of Debt

Figuring out the true cost of a debt after tax is fairly simple. Let's use a student loan debt as an example. Any interest you pay on a student loan is deductible against your income for that year with some limitations.

Currently up to $2500 of student loan interest is deductible for a given tax year, this means that the effective interest rate and true cost of the student loan would be reduced. The amount would vary based on a number of factors including the amount of interest paid annually, your income, and your other tax deductions.

Here is the basic process for figuring out the cost of your student loan debt. Let's say you have $20,000 in student loans carrying an annual interest rate of 5%, this would equate to a $1000 in interest expense for the year.

• First, you need to determine your total taxable income for that year.
• Let's assume for this example you fall into the 25% tax bracket. This assumes your income was between $34,000 and $82,400.
• By taking the $1000 student loan interest deduction on your taxes you saved $250. 1,000 x 25% = $250.
• Subtracting this $250 savings from the $1000 interest expense leaves a true annual cost of $750.

So the cost of this debt, after tax, is $750 making your student loan effective interest rate 3.75%. Keep in mind that there are other tax rules that apply here so make sure you actually qualify to use this deduction before you calculate it into your budget. Another factor to consider is the fact that tax laws change all the time and what is true today may not be true tomorrow.

Things would get much more complicated in our example if the student loan was larger and the annual interest expense was more than the federal limits. This would effectively reduce your tax savings and increase the after tax cost of debt for this loan. You can see in these calculations that a non-deductible loan has a higher true cost than deductible loan interest.

Your After Tax Cost of Debt—Knowing is Important

There are a few reasons why it is helpful to know the true cost of a debt. One of the most important is it allows you to clearly calculate your income and expenses. This gives you a better and more accurate picture of for the coming financial year.

It also allows you to see which of your debts are costing the most relative to their size. Knowing this should give you a pretty good idea on which loans to pay first.

Notes on Income and Tax Brackets

There are a few points to keep in mind when applying this calculation to your specific situation. If you have already filed a recent income tax return, you should have fairly solid numbers to work with for determining your tax bracket.

The less accurate these numbers the more variation you will get in making your estimate of cost. Using the wrong tax bracket can make a big difference to the calculation and give you a skewed answer of how much a debt is costing you.