Tangshan Mining borrowed $10,000 for one year under a line of credit with a stated interest rate of 8 percent and a 10 percent compensating balance. Normally, the firm keeps a balance of about $800 in its checking account. Based on this information, the effective annual interest rate on the loan was 8.89 percent.

Question

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The effective annual interest rate is higher than 8.89 percent because the compensating balance requirement reduces the amount of usable funds, increasing the effective cost of borrowing.

Tangshan Mining Borrowed $10,000 for One Year Under a Line