Break Even Interest Rate Formula
The break even interest rate is according to Brueggeman and Fisher (1993) the interest rate at which borrowed funds that are used for the acquisition of a property investment will have no effect (neither positive nor negative) on the return that the investor will achieve on his/her equity.
The use of borrowed funds can, under certain conditions, magnify the return on the investor’s equity, in which case it is referred to as positive leverage, or reduce the investor’s return, in which case it is referred to as negative leverage.
The break even interest rate (BIR) is the level of interest rate at which the effect of borrowed funds on the investors’ equity return, and therefore the leverage effect, switches from positive to negative. More specifically:
If the mortgage interest rate is HIGHER than BIR ==> Negative Leverage
If the mortgage interest rate LOWER than BIR ==> Positive Leverage
According to Brueggeman and Fisher (1993) BIR can be calculated as:
BIR = After-Tax IRR on Total Funds Invested/(1-investor’s tax rate).
The abbreviation IRR stands for internal rate of return and it is the annual compounded return of a property investment over its projected holding period, given the expected annual cash flows over that period. According to Brueggeman and Fisher, for a given after-tax IRR on total funds (that does not account for any borrowing), the BIR is independent of the amount of borrowing.
Just to see how the formula is applied consider a property investment with an expected after-tax IRR of 15% and an investor with an income tax rate of 20%. Then the break even interest rate can be calculated as:
BIR = 0.10/(1-0.2) = 0.10/0.8 = 12.5%
So if the investor borrows at an effective interest rate of 12.5% then the expected after tax IRR on his/her equity investment will not be affected by the amount of borrowed funds in either way negatively or positively, independently of the amount of money borrowed. However, the actual IRR on the investor’s equity that will be realized by the investment will be affected negatively or positively if the realized after-tax IRR on total funds invested is lower or higher, respectively than BIR.