1

Trying to calculate effective interest rate on loan with the following terms:

  • 128 day term loan
  • 5.4% interest rate
  • 12% compensating balance required

Stuck by idea of compensating balance and how to factor that into the math.

Guest
  • 11
  • 2

1 Answers1

2

If I understand the term, you borrow, say, $1,000,000. You need to pay simple interest at 5.4% for 128 days. Assuming a 365-day year, that works out to $18,936.99, plus the original $1,000,000.00

But because of the compensating balance, you need to turnaround and give $120,000.00 back to the lender. it sits in an account in your name, but you can't access it and you earn no interest. All you can do is get the money out and give it back to the lender as part of you final payment.

In effect, you are borrowing only $880,000.00, and paying $18,936.99 in interest after 128 days.

Can you use the simple interest formula to calculate the interest rate implied by this loan amount, loan period, and interest paid?

DJohnM
  • 4,294
  • 2
  • 15
  • 19
  • Should I not first calculate the nominal interest rate. .. – Guest Sep 28 '14 at 05:40
  • When calculating the interest, should my principle be the amount borrowed or the amount borrowed less the compensating balance – Guest Sep 28 '14 at 05:41
  • You're given a nominal interest rate; the calculation above will produce the true interest rate for the loan, taking the compensating balance into account. Or just divide 5.4% by (1-0.12) – DJohnM Sep 28 '14 at 05:44
  • For the true rate, use the true loan amount and true amount of interest paid.... – DJohnM Sep 28 '14 at 05:46
  • When you say true interest rate, do u mean the same as the effective interest rate? – Guest Sep 28 '14 at 06:27
  • It's the rate that describes what really happened: you borrowed $880,000 and paid it back with $18,936.99 interest in 128 days... – DJohnM Sep 28 '14 at 15:44