Your bank offers you a $140,000 line of credit with an interest rate of 2.30 per

Question

Your bank offers you a $140,000 line of credit with an interest rate of 2.30 percent per quarter. The loan agreement also requires that 7 percent of the unused portion of the credit line be deposited in a non-interest-bearing account as a compensating balance. Your short-term investments are paying 1.55 percent per quarter. What is your effective annual interest rate if you borrow the whole $140,000 for the entire year? What will be the carrying cost in this problem? What will be the shortage cost in this problem?

Please explain all work

Explanation / Answer

     1. Under a line of credit, a borrower can lend money from a lending institution (e.g. bank) on a recurring basis up to a certain amount. The borrower might be required to maintain a deposit that does not earn interest. Such a deposit is called a compensating balance that is usually presented as a percentage of the loan. If a compensating balance is placed on the unused portion of the line of credit, the interest rate will be smaller.

EAR =

Principal x Interest Rate

Principal – Compensating Balance

EAR = $140,000*(2.3%*4)/140000-0

         = 0.092

         = 9.2%

                                = $12880

EAR =

Principal x Interest Rate

Principal – Compensating Balance

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