Suppose your firm is seeking a 3-year, amortizing $300,000 loan with annual payments and your bank is offering you the choice between a $305,000 loan with a $5,000 compensating balance and a $300,000 loan without a compensating balance. If the interest rate on the $300,000 loan is 8 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) 8 percent
B) 7.09 percent
C) 1.67 percent
D) 7.98 percent

Question

Quizplus · Accepted Answer

To choose the loan with the compensating balance, its effective interest rate must be lower than the 8 percent offered on the loan without a compensating balance. The effective interest rate on the loan with the compensating balance is calculated considering the actual amount available for use ($300,000) versus the total amount to be repaid. The answer 7.09 percent represents the maximum effective interest rate on the $305,000 loan (accounting for the $5,000 compensating balance) that would make it more attractive than the 8 percent loan without a compensating balance.

Suppose Your Firm Is Seeking a 3-Year, Amortizing $300,000 Loan