Suppose your firm is seeking a 5-year, amortizing $900,000 loan with annual payments and your bank is offering you the choice between a $950,000 loan with a $50,000 compensating balance and a $900,000 loan without a compensating balance. If the interest rate on the $900,000 loan is 9.5 percent, how low would the interest rate on the loan with the compensating balance have to be in order for you to choose it?
A) 9.5%
B) 5.56%
C) 7.43%
D) not enough information is given to determine

Question

Quizplus · Accepted Answer

To compare the effective cost of the two loans, the interest rate on the $950,000 loan with a $50,000 compensating balance must be calculated such that the effective interest rate is equal to or lower than the 9.5% rate on the $900,000 loan. The effective loan amount is $900,000 ($950,000 - $50,000), and the interest rate that equates the payments on this effective loan amount to the payments on the $900,000 loan at 9.5% is approximately 7.43%.

Suppose Your Firm Is Seeking a 5-Year, Amortizing $900,000 Loan