The after-tax cost of debt is the interest rate on a loan multiplied by one minus the borrower’s marginal tax rate. It represents what borrowing actually costs once the tax deduction on interest is taken into account. A company paying 7% on a loan at a 21% federal tax rate has an after-tax cost of debt of 5.53%, because the deduction lets the government absorb part of the interest expense.
The Formula
After-tax cost of debt = Interest rate × (1 − Marginal tax rate)
Two inputs, and both need care. The interest rate is what you actually pay on the debt right now. For a fixed-rate loan, that’s the stated coupon. For variable-rate debt, use the current rate, not the rate at origination.
The marginal tax rate is the rate that applies to your last dollar of income, not your average or effective rate. That distinction matters. An interest deduction reduces income from the top down, so the dollars saved come off at the highest rate you pay.
A Corporate Example
Take a U.S. corporation borrowing at 7%. The federal corporate tax rate is a flat 21%, unchanged by the One Big Beautiful Bill Act of 2025.
7% × (1 − 0.21) = 7% × 0.79 = 5.53%
For every $100,000 of interest the company pays, it saves $21,000 in federal tax. Net cash cost: $79,000.
An Individual Example
An individual in the 24% federal bracket with a deductible mortgage at 6.5%:
6.5% × (1 − 0.24) = 6.5% × 0.76 = 4.94%
For 2026, the individual federal brackets are 10%, 12%, 22%, 24%, 32%, 35%, and 37%, with the top rate applying to taxable income above $640,600 for single filers and $768,700 for married couples filing jointly.1Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026, Including Amendments From the One, Big, Beautiful Bill
When the Formula Doesn’t Apply
The math only works when the interest is actually deductible. If it isn’t, the after-tax cost equals the pre-tax cost. Section 163(h) of the Internal Revenue Code disallows deductions for “personal interest” paid by anyone other than a corporation.2Office of the Law Revision Counsel. 26 USC 163 – Interest That sweeps in credit card debt, personal auto loans, and most other consumer borrowing not tied to a business, investment, or qualifying residence. Your credit card at 22% has an after-tax cost of 22%.
The statute carves out several exceptions:
- Interest on loans used in a trade or business remains deductible, subject to the cap discussed below.
- Interest on up to $750,000 of acquisition debt secured by a primary or secondary home is deductible if you itemize, or $375,000 if married filing separately.3Internal Revenue Service. Publication 936 (2025), Home Mortgage Interest Deduction
- Interest on debt used to buy taxable investments is deductible up to your net taxable investment income for the year, with anything beyond carrying forward.
- Up to $2,500 per year in student loan interest is deductible as an above-the-line adjustment, phased out at higher incomes and unavailable to married filers filing separately.4Internal Revenue Service. Student Loan Interest Deduction
- For tax years 2025 through 2028, interest on qualifying passenger vehicle loans is temporarily deductible under a new provision added by the One Big Beautiful Bill Act.2Office of the Law Revision Counsel. 26 USC 163 – Interest
The 30% Cap on Business Interest
Even when business interest is deductible in principle, Section 163(j) caps the deduction. In any given year, the deduction cannot exceed the sum of the business’s interest income, 30% of its adjusted taxable income, and any floor plan financing interest.5Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense Interest above the cap carries forward.
Two things soften the blow. The One Big Beautiful Bill Act permanently restored the more generous method of computing adjusted taxable income by adding back depreciation, amortization, and depletion, which gives capital-intensive businesses a larger base. And small businesses with average annual gross receipts of $32 million or less (for 2026) are exempt from the cap entirely under Section 448(c). If your company qualifies, use the formula at face value.
For larger businesses that hit the ceiling, the real after-tax cost is a bit higher than the formula shows, because a portion of the interest doesn’t generate a current-year deduction. The carried-forward interest eventually helps, but the delay costs you.
The Itemization Trap for Homeowners
Mortgage interest and investment interest deductions only help if you itemize. For 2026, the standard deduction is $32,200 for married couples filing jointly, $16,100 for single filers, and $24,150 for heads of household.1Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026, Including Amendments From the One, Big, Beautiful Bill If your itemized deductions (mortgage interest, state and local taxes, charitable contributions, and so on) don’t clear that threshold, you take the standard deduction and get no tax benefit from the mortgage.
This is where the math frequently breaks down for homeowners. Consider a couple paying $14,000 in mortgage interest and assuming a 24% subsidy on every dollar. If their total itemized deductions come to $30,000, they’re still below the $32,200 standard deduction. The mortgage deduction produces nothing, and their after-tax cost of debt equals the stated rate. The formula only delivers real savings when itemizing actually beats the standard deduction.
Adding State Income Taxes
The basic formula uses only the federal marginal rate, but most borrowers also owe state income tax. State corporate rates range from about 2% to roughly 11.5%, and individual rates vary similarly. Because states generally allow interest deductions too, the combined tax benefit exceeds the federal piece alone.
The straightforward approach is to add the federal and state marginal rates and use the combined figure. A corporation in the 21% federal bracket facing a 7% state rate would use 28%:
7% × (1 − 0.28) = 5.04%
Compare that to 5.53% federal-only. A more precise method accounts for state taxes being deductible against federal income, which slightly reduces the effective combined rate, but the additive shortcut is close enough for most planning. In states with no income tax, the federal-only formula is already complete.
Why This Number Feeds Into WACC
The weighted average cost of capital blends a company’s cost of equity and its after-tax cost of debt into one rate that represents the minimum return the business needs on its assets. The after-tax figure goes into WACC, not the pre-tax rate, because the tax shield is a real cash-flow benefit that lowers the true cost of the debt component.
Skip the tax adjustment and you overstate the cost of debt. That makes the company look like it needs higher returns than it actually does, which leads to rejecting profitable projects and undervaluing the business. It’s the main reason analysts track the after-tax number rather than the headline interest rate.
Recalculate When Rates Change
The after-tax cost of debt moves opposite to tax rates, even when the loan itself doesn’t change. Higher rates make the deduction more valuable and push the net cost down. Lower rates shrink the shield and push it up. A 7% loan at a 35% tax rate had an after-tax cost of 4.55%. When the corporate rate dropped to 21% in 2018, that same loan’s after-tax cost rose to 5.53%. The loan didn’t change. The economics did.
The One Big Beautiful Bill Act made the current individual brackets permanent, so 2026 rates stay at 10% through 37%.1Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026, Including Amendments From the One, Big, Beautiful Bill Any future tax bill that raises or cuts rates will shift the numbers again. Whenever a major law passes, spend the two minutes to rerun the formula.