Question

The Crane Bank requires borrowers to keep an 6 percent compensating balance. Gorman Jewels borrows $470,000 at a 8 percent stated APR. What is the effective interest rate on the loan?

Answer 1

The effective interest rate is computed as shown below:

Computation of amount which is deposited as compensating balance is shown as follows:

= Amount borrowed x compensating balance

= $ 470,000 x 6%

= $ 28,200

So, the effective borrowing amount is computed as follows:

= Amount of borrowing - Amount deposited as compensating balance

= $ 470,000 - $ 28,200

= $ 441,800

Interest expense is computed as follows:

= Amount of borrowing x interest rate

= $ 470,000 x 8%

= $ 37,600

So, the effective interest rate will be as follows:

= Interest expenses / Effective borrowing amount

= $ 37,600 / $ 441,800

= 8.51% Approximately

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