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    Effective rate with compensating balance

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    Costs of Borrowing. You've worked out a line of credit arrangement that allows
    you to borrow up to $50 million at any time. The interest rate is .425 percent per
    month. In addition, 4 percent of the amount that you borrow must be deposited in a
    noninterest-bearing account. Assume that your bank uses compound interest on its
    line-of-credit loans.

    a) What is the effective annual interest rate on this lending arrangement?
    b) Suppose you need $10 million today and you repay it in six months. How much interest will you pay?

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    Solution Preview

    a) Suppose you borrow $50 million for a year, you will pay interest 0.425% per month. The compound interest formula is
    CI = P*(1+R)^n-P
    here P=50, R=0.425/100, n=12 - since rate is monthly, so 12 periods in a ...

    Solution Summary

    The solution explains how to calculate the effective cost of borrowing with compensating balance