Suppose your firm is seeking a 7-year, amortizing $100,000 loan with annual payments and your bank is offering you the choice between a $110,000 loan with a $10,000 compensating balance and a $100,000 loan without a compensating balance. If the interest rate on the $100,000 loan is 7 percent, how low would the interest rate on the loan with the compensating balance have to be in order for you to choose it?
A) 7 percent
B) 10 percent
C) 4.34 percent
D) Not enough information is given to know

Question

Quizplus · Accepted Answer

The effective interest rate on the loan with the compensating balance must be lower than the 7 percent offered on the $100,000 loan without a compensating balance. The compensating balance effectively reduces the amount of the loan you have access to ($100,000 instead of $110,000), so the interest rate must be lower to compensate for this. Calculating the effective interest rate that would make both options equivalent, considering the compensating balance and the actual amount available for use ($90,000), leads to an effective rate lower than 7 percent, specifically around 4.34 percent.

Suppose Your Firm Is Seeking a 7-Year, Amortizing $100,000 Loan