Rockville Corporation is going to borrow $250,000 from its bank at an APR of 8.5 percent. The bank requires its customers to maintain a 10 percent compensating balance. What is the effective interest rate on this bank loan? Round to 4 decimal places and enter percentages as a decimal

Answer: 0.0944 (4 dp)

Explanation:

To calculate the effective interest rate we will go in stages.

First we calculate the compensated balance deposit of 10%,

= 250,000*10%

= $,25,000

Subtracting it from the loan amount will give us the effective borrowing.

Effective borrowing = 250,000-25,000

= $225,000

Then we find out the interest expense on the original amount which is,

Interest expense = Amount borrowed * Interest rate

= 250,000*8.5%

= $21,250

The reason we calculated the above is because we need that figure in the effective interest rate formula which goes like,

Effective interest rate = Interest expense / Effective borrowing amount

= 21,250/225,000

= 0.094444444

= 0.0944

Effective interest rate is 0.0944 (4 dp)

9.4%

Explanation:

Compensating balance amount = $250,000 * 10% = $25,000

Interest expenses = $250,000 * 8.5% = 21,250

Effective interest rate = $21,250 / ($250,000 - $25,000) = 0.0944, or 9.4%

Therefor, the effective interest rate is 9.4%.

Note: The effective interest rate of 9.4% is higher than the APR of 8.5% because of the compensating balance.