Sarah borrowed $25,000 from her employer at a rate of 1% interest. At the time the loan was made, the CRA's prescribed rate of interest was 3%. Sarah is in a 40% income tax bracket. What is the actual cost (rate)of Sarah's loan? (Assume there are no fluctuations in the prescribed rate of interest.)

Question

Quizplus · Accepted Answer

The actual cost of the loan is the interest rate charged by the lender plus the amount of tax that Sarah will have to pay on the interest income. The interest rate charged by the lender is 1%. The amount of tax that Sarah will have to pay on the interest income is 40% of the interest income. The interest income is $25,000 x 1% = $250. Therefore, the amount of tax that Sarah will have to pay on the interest income is $250 x 40% = $100. The actual cost of the loan is therefore 1% + $100/$25,000 = 1.8%.

Sarah Borrowed $25,000 from Her Employer at a Rate of 1