### What are Effective Interest Rates?

The effective interest rates you pay are a function of how much money you have available and how much money you give up for the use of these funds. In the simplest form of borrowing, a one-year loan of \$ 10,000 at 12% interest will costs \$ 1,200. The effective interest rate is \$ 1,200 / \$ 10,000 or 12%. As we change the costs and/or amount of funds available, the effective interest rate will change.

Example: You borrow \$ 10,000 at 12% which is discounted by the Bank at 10%, thereby reducing the amount of funds you have available. The effective interest rate is:

\$ 1,200 / \$ 9,000 or 13.3%.

Compensating balances also decrease the proceeds of the loan. As proceeds decline, the effective interest rate rises.

Example: You borrow \$ 30,000 at 12%. The Bank requires that you maintain a 10% compensating balance. The effective interest rate is:

\$ 3,600 / (\$ 30,000 - \$ 3,000) = 13.3%.

Written by: Matt H. Evans, CPA, CMA, CFM | Email: matt@exinfm.com | Phone: 1-877-807-8756