When you borrow money from a lender, they'll 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's 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.
The IRS allows interest charges for some loans to be a deductible expense on your federal income tax return. 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?
The easiest calculation to determine your interest payments is the simple interest method. 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). The total cost of interest for three years would be $360.
Lenders sometimes charge administrative fees in addition to interest. You have to use the annualized percentage rate, APR, to determine the actual cost of the borrowed money in this case.
Consider if 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 Customer Demand?
Interest on Mortgages
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 installment loans and paid out over a fixed term for several years, or they 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.
The interest cost on credit cards is calculated on the outstanding balance. The user’s credit score determines the interest rate. High credit scores equal lower interest rates. Some credit cards can charge monthly or annual fees that increase the APR.
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 with these loans as well. 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.
The IRS allows the interest charges for some loans to be a deductible expense on your federal income tax returns.
Interest on Business Loans
Businesses use short- and long-term loans to finance their operations. The deductibility of the interest paid is generally considered a business expense.
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.
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. Both you and the IRS receive a copy. Interest costs on mortgages for your primary residence are deductible on Schedule A, which is 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 unless you're operating as a business, such as if you're a sole proprietor. Businesses can deduct the interest cost on all their loans. Interest costs are deducted from revenues on a company's income statement.
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.