Formal line of credit: Gibbs, Inc., has just set up a formal line of credit of $1 million with First National Bank. The line of credit is good for up to five 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 50 basis points on the unused balance. The firm borrowed $600,000 on the first day the credit line became available. What is the firm's effective interest rate on this line of credit?

Question

Quizplus · Accepted Answer

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

The interest on the borrowed amount of $600,000 at an interest rate of 6.25% would be: 
= $600,000 x 0.0625 
= $37,500

The annual fee on the unused balance of $400,000 (i.e. $1 million minus $600,000) would be: 
= $400,000 x 0.005 
= $2,000

Therefore, the total cost of the credit line is:
= $37,500 + $2,000
= $39,500

To calculate the effective interest rate, we need to divide the total cost by the amount borrowed:
= $39,500/$600,000
= 0.0658

Therefore, the effective interest rate is 6.58%.

Formal Line of Credit: Gibbs, Inc