Barkely's has a line of credit with a local bank in the amount of $125,000. The loan agreement calls for interest of 8% with a compensating balance of 4%, which is based on the total amount borrowed. The compensating balance will be deposited into an interest-free account. What is the effective interest rate on the loan if the firm needs to borrow $58,000 for one year to cover operating expenses?

Question

Quizplus · Accepted Answer

The effective interest rate is calculated by dividing the interest paid by the usable funds. Interest paid is $58,000 * 8% = $4,640. The compensating balance is 4% of $58,000 = $2,320, so usable funds are $58,000 - $2,320 = $55,680. The effective interest rate is $4,640 / $55,680 = 8.33%.

Barkely's Has a Line of Credit with a Local Bank