The after-tax cost of debt is one of the concepts that is often overlooked in business management and business analysis, but debt can actually be free, and it can even make you money.
The cost of debt is not just the interest rate multiplied times the amount of the loan.
That would be the interest expense.
The after-tax cost of the debt includes other factors.
And if you are going to make a decision about whether or not to incur debt, you need to base that decision on all of the factors that go into determining the cost of the debt.
THE AFTER-TAX COST OF DEBT CONCEPT
The starting point would be to determine the true interest rate you will be paying by using the APR Calculator below.
But after you do that, you then have to look at the benefits that you get from having debt, in addition to the benefit of just having the use of the money.
These other benefits are tax benefits, benefits that will have the effect of lowering your taxes.
This is the concept of “after-tax cost of debt.”
THE AFTER-TAX COST OF DEBT CALCULATION
For this we use an online calculator.
Omnicalculator.com/finance/after-tax-cost-of-debt
The Calculation defines cost of debt as the market interest rate, or yield to maturity, and is designed to assist in determining the cost to a company that wants to incur new debt for expansion purposes.
But the Calculation will also explain the concept that we are talking about.
The key to the after-tax cost of debt is the fact that the interest paid on the debt is usually tax-deductible, meaning it is deducted as an expense from your Gross Income in determining your Net Income, or Taxable Income.
The Calculation uses an example of a business issuing bonds to borrow funds, and I urge you to go through the steps to see the results and how all of the various parts are related to each other. It will make the concept clear.
But we are a Small Business, and we are likely to just get a bank loan.
So I will show you the after-tax cost of debt that applies to your situation.
AFTER-TAX COST OF DEBT EXAMPLE
Let’s say that you are a construction company operating as a Single Member LLC (SMLLC) and the income of the LLC passes through to you to be reported on your personal tax return, and the amount of income is around $65,000.
That puts you in the 22% marginal tax bracket.
One of the largest expenses of the company is $20,000 for excavation work. And you know that you can buy an Excavator for a total of $50,000 but you don’t have the cash. However, the equipment dealer is willing to finance the deal for five years at 6%.
If you do this deal, what is your after-tax cost of debt?
DETERMINING THE APR
First, we need to determine the “actual percentage rate” instead of the “stated percentage rate” of 6%.
For this we go to
Calculator.net/apr-calculator.html
There are actually two Calculators on the site, one to determine the General APR, and another one to determine the Mortgage APR.
We’ll use the General APR Calculator.
1.) Enter 50000 for Loan Amount.
2.) Enter 5 for years and 0 for months.
3.) Enter 6 for Interest Rate.
4.) Enter Monthly (APR) for Compound.
5.) Enter Every Month for Payback.
6.) Enter 0 for Loaned Fees.
7.) Enter 0 for Upfront Fees.
Click Calculate, and look at the results.
AFTER-TAX COST OF DEBT NUMBERS
As you will see, your APR is the same as your stated interest rate.
This is because all of the cost in addition to the sticker price of the Excavator were included in the total amount financed. But if you are dealing with a situation where you have a principal loan amount, and then you have other costs of the transaction, your APR will be higher than your stated interest rate.
Your Monthly Payment is $966.64.
Your Total Interest for the five years of the loan will be $7,998.40.
Now, click on View Amortization Table.
DEBT AMORTIZATION TABLE
You will see a breakdown of 18 of the 60 payments, the principal and interest portion of each one, and the Remaining Principal Balance after each payment.
This Amortization Schedule does not have a starting date and ending date, and it does not show a cumulative total for the Principal and the Interest payments for each tax year. I have one that does that in my book “50 Real Estate Investing Calculations” or you can go here and use this one, it is very good.
MortgageCalculator.org/calcs/amortization.php
So, we will assume that the first 12 payments occurred in the first year, and just add the interest portions each payment, and we get $2,759.53 interest paid in the first year.
But the interest paid decreases each month, and so the total amount of interest paid for each year will be different. And since we are analyzing the debt for the entire five years, it would be more accurate if we took the total amount of interest that will be paid, and divide it by five.
We get an average yearly interest cost of $1,599.68 and we are going to round that to $1,600 for the sake of simplicity.
Your cost of debt is $1,600.
But this is before you consider all of the tax benefits you have created with the debt.
THE TAX BENEFITS OF DEBT
The first benefit is that the interest payments are an expense of doing business and are deductible from your income before taxes.
Therefore, the interest expense deduction will reduce your taxable income by $1,600.
And since you are in the 22% marginal tax bracket, this will reduce your taxes by $352.
The second tax benefit is that you will be able to claim a depreciation allowance on the Excavator. It has a depreciable life of five years, so you can claim $10,000 each year in Depreciation.
This will reduce your taxable income by another $10,000 and since you are in the 22% marginal tax bracket, this will reduce your taxes by $2,200.
So the total tax benefits created by the debt is $2,552.
And your cost of debt was only $1,600.
So you not only reduced your after-tax cost of debt to zero, it went further and increased your income by $952.
And that is just the tax benefit.
On the operational side, you paid an additional $10,000 each year in loan principal to purchase the Excavator, but you saved $20,000 each year that you had been paying a third party to have this work done. So your annual income would have increased by $10,000.
This increased income amount of $10,000, after paying your 22% marginal tax rate, would be $7,800.
Another way to look at it is that your after-tax cost of debt is $1,248 (1,600 – 352), which is about 4.68%, but you gained another $10,000 in income because you eliminated $20,000 in expenses by paying $10,000 loan principal, and then deducted $10,000 in depreciation, making the additional $10,000 income tax-free.
You can see why it is always a good idea to dive deep into the use of debt, and understand all of the benefits by projecting and analyzing the numbers.
CONCLUSION
Depreciation plays a large part in the analysis of business debt, and I recommend another Blog Post called “Depreciation Is A Fraud.”
I cover this same concept in more than one of my books, but the one with the most detailed information is “Do This, Not That!” and you can find it here on this website. Use the 3D Flip Reader to look at the Contents and read the first few chapters.
The paperback is available on my Amazon Author Page, along with my other books.
And I have related Articles about tax matters from other perspectives on my LinkedIn Page.
I am also active on Quora.com where I have answered over 300 questions, and they have almost 3 Million views.
If you happen to be doing, or if you are considering doing, a Section 1031 Like Kind Exchange, then debt will pay a major part in that, and I have a lot of material for you to consider on my S1031 Exchange website.
You should always check out the credentials of anyone, like myself, who you are relying on for accurate information by looking closely at their Biography. Here’s mine.
If you are interested in exploring my Catalog of Real Estate Investing books, but don’t know where to start, I suggest these three.
Thank you.
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DISCLAIMER: I am an Attorney licensed to practice in Texas, North Carolina, Virginia, and the District of Columbia. But I am not your Attorney. I would be honored if I were, but I am not. Reading this Blog does not created an attorney-client relationship between us. Internet content should not be used as a substitute for the advice of a competent Attorney admitted or authorized to practice law in your state or jurisdiction.
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