Formal line of credit: Trend, Inc., has just set up a formal line of credit of $5 million with First National Bank. The line of credit is good for up to three years. The bank will be charging them an interest rate of 7.5 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 $2,300,000 on the first day the credit line became available. What is the firm's effective interest rate on this line of credit? Round to one decimal place.

Question

Quizplus · Accepted Answer

The interest paid on the loan is calculated as follows:
Interest = Amount Borrowed x Interest Rate
Interest = $2,300,000 x 0.075
Interest = $172,500

The annual fee paid on the unused balance is calculated as follows:
Annual Fee = Unused Balance x 0.005
Annual Fee = ($5,000,000 - $2,300,000) x 0.005
Annual Fee = $8,500

The total cost of borrowing is the sum of the interest and the annual fee:
Total Cost = Interest + Annual Fee
Total Cost = $172,500 + $8,500
Total Cost = $181,000

The effective interest rate is the total cost of borrowing expressed as a percentage of the amount borrowed:
Effective Interest Rate = (Total Cost / Amount Borrowed) x 100%
Effective Interest Rate = ($181,000 / $2,300,000) x 100%
Effective Interest Rate = 7.87%

Rounding to one decimal place gives an effective interest rate of 8.1%, which is closest to choice (D).

Formal Line of Credit: Trend, Inc