What are Effective Interest Rates?
The effective interest rates you pay are a function of how much money you have available and how much money you give up for the use of these funds. In the simplest form of borrowing, a one-year loan of $ 10,000 at 12% interest will costs $ 1,200. The effective interest rate is $ 1,200 / $ 10,000 or 12%. As we change the costs and/or amount of funds available, the effective interest rate will change.
Example: You borrow $ 10,000 at 12% which is discounted by the Bank at 10%, thereby reducing the amount of funds you have available. The effective interest rate is:
$ 1,200 / $ 9,000 or 13.3%.
Compensating balances also decrease the proceeds of the loan. As proceeds decline, the effective interest rate rises.
Example: You borrow $ 30,000 at 12%. The Bank requires that you maintain a 10% compensating balance. The effective interest rate is:$ 3,600 / ($ 30,000 - $ 3,000) = 13.3%.
Written by: Matt H. Evans, CPA, CMA, CFM | Email: firstname.lastname@example.org | Phone: 1-877-807-8756
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