New Town Bank offers you a $40,000 line of credit with an interest rate of 1.6 p
ID: 2816421 • Letter: N
Question
New Town Bank offers you a $40,000 line of credit with an interest rate of 1.6 percent per quarter. The loan agreement also requires that 3 percent of the unused portion of the credit line be deposited in a non-interest-bearing account as a compensating balance. Short-term investments are currently paying 1.1 percent per quarter. What is the effective annual interest rate on the line of credit if you borrow the entire $40,000 for one year? Assume any funds borrowed or invested use compound interest.
Explanation / Answer
Effective interest rate = (1 + r / m)m - 1
where, r = annual rate of interest, m = no. of times compounded in a year
Since interest is payable per quarter, we have quarterly or 4 times compounding in a year. We are already given r / m as 1.16% or 0.016 -
Effective annual interest rate = (1 + 0.016)4 - 1 = 0.0656 or 6.56%