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What Does “Effective Tax Rate” Mean?

What does it mean when you hear the phrase “effective tax rate?” If you are the lender, it means how much interest you are earning. It’s also called the true interest rate, the yield to maturity on a bond, or the internal rate of return. But if you are the one borrowing the money, the effective tax rate is something a bit different.

Imagine you are going to buy a new house and the bank will charge you 5% interest on a mortgage. The 5% interest rate is the nominal or stated interest rate. It’s the interest rate the bank is charging you. But, mortgage interest is deductible against your income for income tax purposes. This means that although you are paying the bank 5% interest, because of the interest deduction you get, your “real” interest rate after taking into consideration the break you get on your taxes is going to be less than 5%. This is your true effective tax rate.

To calculate your effective tax rate or interest rate after tax, you can use this mortgage loan tax deduction calculator from Bankrate.

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