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Computing The Effective Annual Interest Rate on Loans

Your firm is considering the following three alternative bank loans for $1,000,000:

a) 10% loan paid at year end with no compensating balance
b) 9% loan paid at year end with a 20% compensating balance
c) 6% loan that is discounted with a 20% compensating balance requirement

Assume that you would normally not carry any bank balance that would meet the 20% compensating balance requirement. What is the rate of annual interest on each loan?

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Solution Preview

A compensating balance is a balance kept on deposit with the lender which the borrower does not have use of. However, the compensating balance is considered to be part of the loan and interest is charged on it.

a) The interest due on a 10% loan of $1,000,000 paid at year ...

Solution Summary

This solution illustrates how to compute the effective annual interest rate on three loans: a loan with no compensating balance, a loan with a compensating balance, and a loan issued at a discount to face value with a compensating balance.