Storm Electronics has set up a formal line of credit of $2 million with First Kentucky Bank. The line of credit is good for up to three years. The bank will be charging them an interest rate of 6.25 percent on the loan, and in addition the firm will pay an annual fee of 60 basis points on the unused balance. The firm borrowed $1,500,000 on the first day the credit line became available. What is the firm's effective interest rate on this line of credit? Round your final percentage answer to two decimal places.
A) 7.50%
B) 6.45%
C) 6.25%
D) 7.15%

Question

Quizplus · Accepted Answer

To calculate the effective interest rate, we need to consider both the interest rate charged on the borrowed amount and the annual fee on the unused balance.

For the amount borrowed of $1,500,000, the interest charged would be:

Interest = $1,500,000 x 6.25% = $93,750

For the unused balance of $500,000 ($2,000,000 - $1,500,000), the annual fee would be:

Annual fee = 0.0060 x $500,000 = $3,000

Total cost of credit = Interest + Annual fee = $93,750 + $3,000 = $96,750

To calculate the effective interest rate, we divide the total cost of credit by the amount borrowed, and express it as a percentage:

Effective interest rate = ($96,750 / $1,500,000) x 100% = 6.45%

Therefore, the answer is B (6.45%).

Storm Electronics Has Set Up a Formal Line of Credit