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The Effective Interest Rate of a Loan (Compensating Bal)

James Supply needs to borrow $150,000 for 6 months. Canada Bank has offered to lend the funds at a 9% annual rate subject to a 10% compensating balance. (Note: James currently maintains $0 on deposit in Canada Bank). Bills Finance Co. has offered to lend the funds at a 9% annual rate with discount-loan terms. The principal of both loans would be payable at maturity as a single sum.

a. Calculate the effective annual rate of interest on each loan.

"The compensating 10% balance I dont understand, I need help with the formula that is needed to figure this out."

b. What could James do that would reduce the effective annual rate on the Canada Bank loan?
"Would this be to possibly up his deposit in the Canada bank, which in turn would act as a collaterial, or a down payment to possibly get a lower rate on his 6 month loan."

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Solution Preview

a. James is borrowing $150,000 but has use of only $140,000 because he has to maintain a compensating balance (which probably earns him no interest) of $10,000. He will still need to pay $150,000*.09*6/12, or $6,750, but will pay it on the $140,000 he uses; the semi-annual rate, computed as $6,750/$140,000, works out to about 4.82 percent ...

Solution Summary

This solution discusses the computation of the interest rate on a loan with a mandatory compensating balance, as well as ways to avoid the compensating balance requirement.