When you borrow money from someone, they will ask you to pay back the loan with interest. This interest is the cost of borrowing money. Another way to view it is that it is the cost of using their money. The amount of interest expense depends on the size of the loan, the interest rate and the length of time it takes you to repay the loan.
For some loans, the IRS allows the interest charges to be a deductible expense on your federal income tax returns. Let's examine the various types of personal and business loans, see how interest is calculated and identify which debt obligations are deductible.
How Is Interest Calculated?
Suppose you borrow $1,000 at an interest rate of 12 percent for three years. The interest cost for one year would be $120 (12 percent times $1,000). So, the total cost of interest for three years would be $360.
Consider if in the example the lender charged a $50 administrative fee to set up the loan. The total charges for the loan would then be $410 ($50 + $360). The APR becomes 13.7 percent ($410/$1,000/3 years X 100).
APRs are always higher than a simple interest rate
Read more: How do Interest Rates Affect the Customer Demand?
Interest on Personal Loans
Mortgage: Mortgage interest rates can be either fixed or variable. Mortgage APRs usually include origination fees, mortgage insurance and taxes. Loans payments on mortgages are fixed and include principal amortization, interest charges, taxes and property insurance. The proportion of interest costs in the payment goes down over time as the outstanding principal is paid down.
Fixed-rate mortgages can range from 10 to 40 years. Variable-rate mortgages are priced on a spread over a base rate, such as the prime rate, and change over time with fluctuations in interest rates.
Home equity loans: Loans based on a percentage of a home's equity can be either an installment loan and paid out over a fixed term for several years, or can be set up as a revolving line of credit. Home equity installment loans usually have a fixed rate, while revolving lines of credit have fluctuating interest costs based on the outstanding balance.
Credit cards: Interest cost on credit cards is calculated on the outstanding balance The user’s credit score determines the interest rate. High credit scores equal high interest rates. Some credit cards can charge monthly or annual fees that increase the APR.
Vehicle loans: Loans for cars, boats, SUVs and other vehicles usually have fixed interest rates with repayment terms spread over several years. The interest rate varies with the credit score of the borrower. Vehicle loans can come with additional fees such as sales tax, administrative costs and title fees. You have to calculate the APRs to find the best rates offered by various lenders.
For some loans, the IRS allows the interest charges to be a deductible expense on your federal income tax returns.
Interest on Business Loans
Business uses short- and long-term loans to finance their operations. The deductibility of the interest paid is generally considered a business expense.
Line of credit: Many businesses have short-term revolving lines of credit arrangements with their banks to cover business expenses. Interest rates are usually charged at a spread over the bank’s prime rate, and interest charges vary with the amount borrowed against the line of credit.
Long-term debt: Businesses use long-term loans to finance fixed assets, such as property, plants and equipment. Interest rates are usually fixed but can also include fees for administrative costs to set up the loan.
Is Interest Tax Deductible?
Your lender reports the interest paid using Form 1098. Interest costs on mortgages for your primary residence are deductible on Schedule A and filed with Form 1040. Interest costs on home equity loans may be deductible if the proceeds were used to make home improvements, not to take a vacation.
Interest rates on personal revolving credit lines and vehicle loans are not deductible.
Businesses can deduct the interest cost on all of their loans. Interest costs are deducted from revenues on a company's income statement.
- Bankrate: Interest Rate
- the balance: What Is Interest?
- Credit.com:How Interest Rates Work
- Investopedia: Interest Rate
- Wallethub: What Is an Interest Rate? Definition, Examples, & More
- Entrepreneur: Everyday Money: Why Your Credit Score Matters
- Entrepreneur: 5 Best and Fast Small-Business Loans
- Internal Revenue Service: Form 1040
- Bank of America. “APR vs. Interest Rate.” Accessed April 2, 2020.
- Consumer Financial Protection Bureau. “What Is the Difference Between a Mortgage Interest Rate and an APR?” Accessed April 2, 2020.
- Consumer Financial Protection Bureau. “What Is a ‘Daily Periodic Rate’ on a Credit Card?” Accessed April 2, 2020.
- Consumer Financial Protection Bureau. "How to Understand Special Promotional Financing Offers on Credit Cards." Accessed April 4, 2020.
- Consumer Financial Protection Bureau. “What Is a Balance Transfer Fee? Can a Balance Transfer Fee Be Charged on a Zero Percent Interest Rate Offer?” Accessed Jan. 16, 2020.
- Consumer Financial Protection Bureau. “You Could Still End Up Paying Interest on a Zero Percent Interest Credit Card Offer.” Accessed April 4, 2020.
- Experian. “What You Need to Know About 0% APR Credit Card Offers.” Accessed April 4, 2020.
- Code of Federal Regulations. “Comment for 1026.60 - Credit and Charge Card Applications and Solicitations.” Accessed April 4, 2020.
- Consumer Financial Protection Bureau. “What Is the Difference Between a Fixed APR and a Variable APR?” Accessed Jan. 16, 2020.
- Citizens Bank. “What Is APR?” Accessed April 4, 2020.
- Experian. “What Is APR and How Does It Affect Me?” Accessed April 4, 2020.
- Consumer Financial Protection Bureau. "Differentiating Between Securedand Unsecured Loans." Accessed April 4, 2020.
- Consumer Financial Protection Bureau. "What is a Loan-to-Value Ratio and How Does It Relate to My Costs?" Accessed April 4, 2020.
- Consumer Financial Protection Bureau. "What is a Debt-to-Income Ratio? Why is the 43% Debt-to-Income Ratio Important?" Accessed March 4, 2020.
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for work.chron, bizfluent.com, smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.