Bank Two extends a $3 million line of credit to Capital Corp. The stated rate of interest is 9.5%. Bank Two requires Capital to maintain compensating balances equal to 10% of the amount of the line. Assuming that Capital would not normally carry any deposits at the bank, what is the effective annual rate of interest on the loan?

Question

Quizplus · Accepted Answer

Since Bank Two requires Capital to maintain compensating balances equal to 10% of the amount of the line ($3 million), Capital must keep $300,000 in a deposit account at the bank. This reduces the amount of the loan that Capital can actually use to $2,700,000 ($3 million - $300,000).

The interest on the loan is calculated on the full $3 million, so at a stated rate of 9.5% the interest charge would be $285,000 ($3 million x 9.5%).

However, since Capital can only use $2,700,000 of the line, the effective interest rate becomes:

Effective rate = Total interest / amount of funds available to use 
Effective rate = $285,000 / $2,700,000 
Effective rate = 10.6%

Therefore, the effective annual rate of interest on the loan is 10.6%.

Bank Two Extends a $3 Million Line of Credit to Capital