A company obtained a short-term bank loan of $250,000
at an annual interest rate of 6%. As a condition of the loan, the
company is required to maintain a compensating balance of
$50,000 in its checking account. The company’s checking account
earns interest at an annual rate of 2%. Ordinarily, the
company maintains a balance of $25,000 in its checking account
for transaction purposes. What is the effective interest rate of the
loan?

(a) The requirement is to calculate the effective interest
on the loan. Answer (a) is correct because the effective interest is
6.44%. The effective interest rate is determined by calculating
the net interest expense, which is $15,000 ($250,000 × 6%) minus
the interest income from the compensating balance $500
($25,000 × 2%) equals $14,500. Then, this amount is divided by
the amount of money that the firm has available, $250,000 –
$25,000 compensating balance. Thus, the effective interest rate
is 6.44% ($14,500/$225,000).