Midland Chemical Co. is negotiating a loan from Manhattan Bank and Trust. The
small chemical company needs to borrow $500,000.
The bank offers a rate of 8¼ percent with a 20 percent compensating balance
requirement, or as an alternative, 9¾ percent with additional fees of $5,500 to cover
services the bank is providing. In either case the rate on the loan is floating (changes as
the prime interest rate changes), and the loan would be for one year.
a. Which loan carries the lower effective rate? Consider fees to be the equivalent of
b. If the loan with a 20 percent compensating balance requirement were to be paid
off in 12 monthly payments, what would the effective rate be? (Principal equals
amount borrowed minus the compensating balance.)