Suppose you borrow R2,000 from a bank for one year at a stated annual interest rate of 14 percent, with interest prepaid (a discounted loan).Also assume that the bank requires you to maintain a compensating balance equal to 20 percent of the initial loan value.What effective annual interest rate are you being charged?

Question

Quizplus · Accepted Answer

The effective annual interest rate is calculated by considering both the interest prepaid and the compensating balance. The interest prepaid is R280 (14% of R2,000), so you receive R1,720. However, you must maintain a compensating balance of R400 (20% of R2,000), so you effectively have access to R1,320. The effective interest rate is then R280/R1,320 = 21.21%.

Suppose You Borrow R2,000 from a Bank for One Year