Your bank offers you a $40,000 line of credit with an interest rate of 2.35% per quarter. The loan agreement also requires that 5% 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 1.75% per quarter. What is your effective annual interest rate if you borrow the whole $40,000 for the entire year? Assume that both the funds you borrow and the funds you invest use compound interest.

Question

Quizplus · Accepted Answer

The effective annual interest rate is 9.74%. This is because the interest rate on the loan is 2.35% per quarter, and the compensating balance requirement means that 5% of the unused portion of the credit line must be deposited in a non-interest bearing account. This means that the effective interest rate on the loan is 2.35% * (1 - 5%) = 2.24%. The effective annual interest rate is then 2.24% * 4 = 9.74%.

Your Bank Offers You a $40,000 Line of Credit with an Interest