Llewellyn Sinclair is planning to borrow $40,000 for one year, paying interest of $2,400 to a...

Question:

Llewellyn Sinclair is planning to borrow $40,000 for one year, paying interest of $2,400 to a bank at the beginning of the year (discount loan). In addition, according to the terms of the loan, the bank requires Sinclair to keep 10%of the borrowed funds in a non-interest-bearing checking account at the bank during the life of the loan.

Calculate the effective annual interest rate.

Effective Interest Rate

Effective interest rate is the interest rate that is paid on the effective usage of the loan or fund. Simply stated, effective rate is the total interest paid on the loan divided by the effective loan amount at disposal.

Answer and Explanation:


Given,

  • Amount borrowed = $40,000
  • Interest Paid = $2,400 at the beginning of the year
  • Deposit kept with bank in non-interest bearing checking account = 10% of loan amount = $4,000

Effective loan amount = Total loan - upfront interest paid - deposit in checking account

Effective loan amount = $40,00 - 2,400 - $4,000 = $33,600

Effective interest rate = Total interest paid / Effective loan amount

Effective interest rate = $2,400 / $33,600

Effective interest rate = 0.0714 = 7.14%

Hence, the effect interest rate paid on the loan is 7.14%


Learn more about this topic:

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How to Calculate Interest Expense: Formula & Example

from Financial Accounting: Help and Review

Chapter 5 / Lesson 18
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