A company obtained a short-term bank loan of $250,000 at an annual interest rate of 6%. As a condition of the loan, the company is required to maintain a compensating balance of $50,000 in its checking account. The company's checking account earns interest at an annual rate of 2%. Ordinarily, the company maintains a balance of $25,000 in its checking account for transaction purposes. What is the effective interest rate of the loan?
If a firm borrows $250,000 but is required to maintain $50,000 as a minimum compensating balance, then the firm only has use of $200,000, but is paying 6% interest on the entire $250,000. To determine the effective interest rate, the interest in dollars ($250,000 × 6%, or $15,000) should be divided by the amount of the loan available to the borrower, the effective loan amount, which is only $200,000. However, there are two issues that further complicate this problem. This company ordinarily maintains a $25,000 balance in its checking account. Therefore, the company will only be out $25,000 ($50,000 - $25,000). This means the effective loan amount is $225,000 ($250,000 - $25,000), not $250,000. Also, the company earns checking account interest which partially offsets the loan interest. The applicable amount on which to determine interest is only the part that pertains to this borrowing, the additional $25,000. The interest on this is $500 (2% × $25,000). The effective interest dollar amount for this borrowing is $14,500 ($15,000 - $500). The effective interest rate is now calculated as:$14,500 ÷ $225,000 = .0644, or 6.44% effective interest rate