Overview

Main Menu Name: Loan Rate

Calculates the break-even interest rate on a loan, given the after-tax return on the investment and the investor's marginal tax bracket, the after-tax cost of borrowing, and the percentage tax saving from the use of borrowed funds rather than equity capital.

In this article:

• Background
• Why should I use this calculator?
• Getting Started
• Entering Data
• Results

Background

In making any major investment, especially in real estate, financing options must be considered. Investors must decide how much capital to invest, how much can or should be borrowed, what sources of borrowing are available, and what the cost of borrowing would be. Such decisions affect the net cash flow from the investment, its overall profitability, and the rate of return on the capital.

Taxes are important considerations since investment interest payments are deductible, up to certain limits, for income tax purposes. Tax deductibility often makes borrowing a more attractive approach than equity funding because dividends paid to equity investors are not tax deductible. In contrast, dividends paid to equity investors are not tax deductible.

The tax deductibility of interest payments often makes borrowing to finance an investment, referred to as "financial leverage," a more attractive approach than equity funding. However the risk of default on the debt payments, interest and repayment of principal, adds to the overall risk of the project.

Borrowing to finance a project will be attractive as long as the after-tax interest cost of debt is lower than the rate of return on the project. After this point has been reached, equity financing is more attractive.

Why should I use this calculator?

• To determine the attractiveness of various investments under different financing plans.
• To analyze the impact of financing alternatives on an investment.
• To evaluate the cost of borrowing on the overall rate of return on an investment.
• To decide when to borrow and when to use equity in financing an investment project.

Getting Started

In making any major investment, especially in real estate, financing options must be considered. Investors must decide how much capital to invest, how much can or should be borrowed, what sources of borrowing are available, and what the cost of borrowing would be. Such decisions affect the net cash flow from the investment, its overall profitability, and the rate of return on the capital.

Taxes are important considerations since investment interest payments are deductible, up to certain limits, for income tax purposes. Tax deductibility often makes borrowing a more attractive approach than equity funding because dividends paid to equity investors are not tax deductible. In contrast, dividends paid to equity investors are not tax deductible.

The tax deductibility of interest payments often makes borrowing to finance an investment, referred to as "financial leverage", a more attractive approach than equity funding. However the risk of default on the debt payments, interest and repayment of principal, adds to the overall risk of the project.

Borrowing to finance a project will be attractive as long as the after-tax interest cost of debt is lower than the rate of return on the project. After this point has been reached, equity financing is more attractive.

Entering Data

1.  After-tax Return on Investment:  Enter the after-tax rate of return on the investment.
2.  Investor's Tax Bracket:  Enter the investor's marginal tax bracket.

Results

The program calculates the break-even loan interest rate. This is the point where the after-tax cost of debt just equals the rate of return on the project. The program also calculates the after-tax cost of borrowing, given the investor's tax bracket. And, the percentage tax saving from the use of borrowed funds rather than equity capital.

The program provides interest rates one, four, and six percent above the break-even rate, and interest rates one, two, and three percent below the break-even rate. These variations are useful in comparing different loans, or a single loan with a variable interest rate.