Agriculture Reference
In-Depth Information
$108,000, and his interest rate would have been the same as the stated rate of 8 percent
because he used the entire $100,000 for the entire year. This type of interest is called
simple
interest
. The formula for simple interest is:
(
)
×
Amount of Interest Paid
/
Amount of Available Capital
1
00
=
Annual Interest Rate
8
(
)
×=
$,
000
/$
1
00 000
,
1
00
8
%
Sometimes, however, loans are
discounted
, which means that the amount of interest to be
paid is deducted from the amount the lender makes available to the borrower. If this method
had been used in Doug's case, the $8,000 interest to be paid, or 0.08
$100,000, would have
been deducted from the loan amount, and Doug would have had the use of only $92,000 in
capital. The discounted loan formula is as follows:
×
Amount of Loan
-
Amount of Interest Paid
=
Amount of Available
Capital
At the end of the year, $100,000 would have been repaid to the lender; but because Doug had
the use of only $92,000, the “effective” interest rate was not the stated rate. The “effective”
interest rate for a discounted loan is calculated as follows:
(
)
×
Amount of Interest Paid
/
Amount of Available Capital
1
00
=
Annual Effective Interest Rate
8
(
)
×=
$,
000
/$ ,
92
000
1
00
8 7
.%
The cost of interest on this discounted loan was then 8.7 percent and not the stated rate of
8 percent, because Doug did not get to use the entire amount borrowed even though he paid
interest on the entire amount for the entire time the money was borrowed.
Banks often require that borrowers have a
compensating balance
in their accounts at the
lending bank. To obtain a $100,000 loan, Doug might be required to maintain a minimum
balance of $20,000 in his company bank account while the loan is outstanding. This means
that he would have the use of only $80,000 in additional capital from the loan, while paying
interest on the entire amount borrowed for the entire time the money was borrowed. The
formula for calculating the effective rate of interest in this case is:
(
)
×
Amount of Interest Paid
/
Amount of Available Capital
1
00
=
Annual Effective Interest Rate
8
(
)
×=
$,
000
/$ ,
8
0 000
1
00
1
0
%
If Doug normally carries a cash balance, this amount could be deducted from the compensat-
ing balance to lessen the increase of the effective interest cost.
Sometimes lending institutions also require that a certain number of
points
(service
charges based on the face value of the loan) be paid to obtain the loan. These charges for risk
and loan servicing are made in advance, and the amounts charged are usually deducted from
