Dr. Ruth is going to borrow $1,600 to help write a book. The loan is for one yea

Question

Dr. Ruth is going to borrow $1,600 to help write a book. The loan is for one year and the money can either be borrowed at the prime rate or the LIBOR rate. Assume the prime rate is 11 percent and LIBOR 2.5 percent less. Also assume there will be a $75 transaction fee with LIBOR (this amount must be added to the interest cost with LIBOR).   

a. What is the effective interest rate on the LIBOR loan? (Use a 360-day year. Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
  

   
  
b. Which loan has the lower effective interest cost?
  

Explanation / Answer

Interest Cost on Loan = Interest Rate * Principal Borrowed * (Number of days loan outstanding/360)

a) LIBOR Rate = 11% - 2.5% = 8.5%

Interest Cost = 8.5% * $1600 * (360/360) = $136.

Transaction fees need to be added to this interest cost, to obtain efective cost

Effective interest expense = $136 + $75 = $211

Effective Interest rate = $211/$1600 = 13.19%

b) Prime rate loan has a cheaper interest rate.

Effective interest for LIBOR based loan is 13.19%, and for Prime it is 11%.

Related Questions

Navigate

• Browse (All)
• Browse D
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.