Your bank offers you a $25,000 line of credit with an interest rate of 2.25% per quarter. The loan agreement also requires that 4% of the unused portion of the credit line be deposited in a non-interest bearing account as a compensating balance. Your short-term investments are paying 0.40% per month. What is your effective annual interest rate on this arrangement if you do not borrow any money on this credit line during the year? Assume any funds borrowed or invested use compound interest.

Question

Quizplus · Accepted Answer

The effective annual interest rate is calculated by considering the compensating balance requirement. Since you do not borrow any money, the entire $25,000 is unused, requiring a 4% compensating balance of $1,000. This amount is not earning interest, while your investments earn 0.40% monthly. The opportunity cost of not investing the $1,000 is calculated using compound interest, leading to an effective annual interest rate of approximately 4.91%.

Your Bank Offers You a $25,000 Line of Credit with an Interest