Jerry's Company is looking at various financing agreements. New Credit Union has agreed to loan the company $500,000 at 8% interest. Happy Bank has agreed to loan the company $500,000 at an interest rate of 6%

This is the lowest interest rate the company has been offered. However, as a condition to the loan, the company must maintain a compensating balance amount equal to 20% of the loan.

Required:
1. Determine the company's actual (effective) interest rate on the bank loan.
2. Which loan has the lowest interest cost?
What will be an ideal response?

1. Bank loan:
Compensating balance = $500,000 × .20 = $100,000
Total actually borrowed = $500,000 - $100,000 = $400,000
Interest = $500,000 × 0.06 = $30,000
Effective interest = $30,000 ÷ $400,000 = 7.5%

2. The effective interest rate on the bank loan is 7.5% and the interest rate on the credit union loan is 8%. The effective interest rate on the bank loan is lower than 8%. The bank loan has the lower actual (effective) rate of interest.