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# Compensating Balances

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Compensating Balances. A bank loan has a quoted annual rate of 6 percent. However, the borrower must maintain a balance of 25 percent of the amount of the loan, and the balance does not earn any interest.

a. What is the effective rate of interest if the loan is for 1 year and is paid off in one payment at the end of the year?

b. What is the effective rate of interest if the loan is for 1 month?

Problem is attached as a Word document. You must show your work and all formulas.

#### Solution Preview

a. What is the effective rate of interest if the loan is for 1 year and is paid off in one payment at the end of the year?

Method 1:

Compensating balance percent= 25%

let us assume the loan to be equal to \$100

Loan= \$100

Compensating balance required= \$25 =25%*100

Annual interest rate= 6%

annual interest= \$6 ...

#### Solution Summary

Calculates effective rate of interest on the loan where the borrower must maintain a compensating balance.

\$2.49