How to Calculate the After-Tax Cost of Debt — Step by Step

The formula, in one paragraph

Four steps. First, the annual interest: the loan times the pre-tax rate. Second, the tax shield: the interest times your marginal tax rate — the rate on your last dollar of income. Third, the after-tax interest: the interest minus the shield. Fourth, the after-tax rate: the pre-tax rate times one minus the tax rate. That rate is the one that matters: it is the debt term in the weighted average cost of capital, and the rate a business compares against the return on a project.

Step 1: Work out the annual interest

Multiply the loan by the pre-tax interest rate. At the example loan of $100,000 and a rate of 7.5%, the annual interest is $100,000 times 7.5%, which is $7,500.00 a year. That is the interest before tax — the number on the loan statement. At a 10% rate the interest would be $10,000.00, and at 5% it would be $5,000.00. The loan size changes the dollars, never the rate.

Step 2: Work out the tax shield

Multiply the interest by your marginal tax rate. At the example the interest is $7,500.00 and the rate is 24%, so the shield is $7,500.00 times 24%, which is $1,800.00. That is the tax the deduction saves. Use the marginal rate, not the average rate — the deduction shelters your last dollars, taxed at the marginal rate, and the average rate understates the shield. At 32% the shield would be $2,400.00.

Step 3: Subtract to get the after-tax interest

Subtract the shield from the interest. At the example that is $7,500.00 minus $1,800.00, which is $5,700.00 a year — what the debt really costs. Divide by 12 for the monthly figure: $5,700.00 divided by 12 is $475.00 a month. At 32% the after-tax interest would be $5,100.00, a rate of 5.10%, and at 12% it would be $6,600.00.

Step 4: Work out the after-tax rate

Multiply the pre-tax rate by one minus the tax rate. At the example that is 7.5% times (1 minus 24%), which is 7.5% times 76%, or 5.70%. Check it: $100,000 times 5.70% is $5,700.00, the same after-tax interest from Step 3. If your tax rate is 0% — or if the interest is not deductible at all — the after-tax rate is the pre-tax rate: 7.50%, with a shield of $0.00.

Working backwards from a target

The calculation also runs backwards. The pre-tax rate that gives a 4.00% after-tax rate at 24% tax is 5.26%, because 4.00% divided by (1 minus 24%) is 5.2632%. The loan that costs $10,000 a year after tax is $175,438.60, because $10,000 divided by (7.5% times 76%) is 175,438.5965. And the highest pre-tax rate that keeps the after-tax rate at or below 5.00% at 24% tax is 6.58%, because 5.00% divided by 76% is 6.5789%.

When the deduction applies — and when it does not

The shield only exists when the interest is actually deductible. Business debt is deductible, and mortgage interest is deductible when you itemize. If you take the standard deduction instead, your mortgage interest buys you no shield at all — and then the after-tax cost equals the pre-tax cost: 7.5%, not 5.70%. Personal loans, car loans and credit cards are not deductible at all, so there is no shield whatever your tax rate is.

Where it shows up: WACC

The after-tax cost of debt is the debt term in the weighted average cost of capital: WACC equals the equity weight times the cost of equity plus the debt weight times rD times (1 minus T). The rD(1 minus T) in that formula is exactly the after-tax rate in this guide — 5.70% at the example. A company borrowing at 7.5% and paying 24% tax counts its debt at 5.70% when it prices a project.

What NOT to do

Do not use your average tax rate: the deduction shelters your last dollars, taxed at the marginal rate, and the average rate understates the shield. Do not count a shield on interest that is not deductible: a credit card at 7.5% costs 7.5% after tax, not 5.70%. Do not forget that an amortizing loan pays less interest each year as the balance falls, so the shield shrinks with it — the $1,800.00 here is the first-year figure on the full $100,000.

That box is the whole formula.