As a person weighs the options on whether or not to borrow money, the effect on income tax must also be factored into the equation. That means one must understand what the net-effect will be on the cost of borrowing after taxes.
The Net Effect
The after-tax borrowing rate is simply the interest rate charged on the loan x (1 – marginal tax rate); the marginal rate is the amount of tax you pay on the last dollar of income you earned. For example, if the stated rate on a mortgage is 6%, then the after tax effective rate if the interest cost could be deducted would be 6% x (1 – .25) or 4.5% if one was in the 25% marginal tax rate. Sounds good, especially if you want to borrow money at a low rate and invest it to make higher returns—creating the greatest spread between the returns on the investment and the cost of borrowing.
This concept is widely used in financial planning by financial professionals in the justification for borrowing………Only it isn’t true.
The pretax and after-tax interest rate for interest costs that can be deducted from taxes is the same. You see, if you borrow $100,000 at 6%, you will owe $6000 in interest. If the interest is not deductible from taxes, then the interest cost is $6000. If you can deduct the interest from taxes, then the interest cost is still $6000—the lender does not reduce the interest just because the government allows you to deduct the expense on your return.
The truth is that the IRS levies a surcharge on each and every dollar you earn, called an income tax. If you pay an average of 20 cents of tax for each dollar of income earned (called the effective rate), then each expense that is made that is not deductible is actually 20% more than the stated rate. A $200 grocery bill is actually $240 and so on. Therefore, any interest cost that is not deductible, such as on a consumer loan or credit card, is actually 20% more than the stated rate, i.e. 6% would actually be 7.2%.
This is the actual cost of borrowing.
Any expenses that are tax-deductible are those that the IRS waives the surcharge on the income earned to pay those expenses. So, taking our earlier example, the 6% charged on the $100,000 loan would be an actual cost of $6000, allowing a reduction of income tax owed commensurate with one’s marginal rate, in this case 25% or $1500 (since deductions are made from the last dollar earned). This is not a refund from the IRS, but simply a waiver on income tax that would otherwise be owed.
Due to these facts, the myth of the after-tax lending rate gives a borrower a false perception of his actual cost of borrowing. By misrepresenting the actual interest rate, the debtor actually borrows money at a higher rate, taking more risk than he believes he’s taking. The risk on borrowing money for reinvestment at 6% is greater than borrowing at 4.5% since more return must be made to cover the interest costs.
Tax deductible interest and real estate costs do lower the cost of owning a house over renting. Since rent payments are not generally deductible, and (theoretically) cover the costs of ownership for the property owner, the cost of rent would be higher than the costs the owner would incur, especially after the effect of tax deductions.
Tax policy is aimed at rewarding and penalizing certain economic behaviors. The fact that the IRS waives taxes on the income earned to pay certain expenses demonstrates which behaviors are desired, and conversely, which behaviors are not. Obviously, borrowing money against one’s home is one of these desired actions.
Borrowing money is fine, as long as you know what it’s actually costing you.
Wishing you success while you Live Your Art!®