Dr. Ruth is going to borrow $8,800 to help write a book. The loan is for one yea

Question

Dr. Ruth is going to borrow $8,800 to help write a book. The loan is for one year and the money can either be borrowed at the prime rate or the LIBOR rate. Assume the prime rate is 7 percent and LIBOR 1.5 percent less. Also assume there will be a $44 transaction fee with LIBOR (this amount must be added to the interest cost with LIBOR).

a. What is the effective interest rate on the LIBOR loan?(Use a 360-day year. Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

b. Which loan has the lower effective interest cost?

Explanation / Answer

Solution:-

a) Effective interest rate on LIBOR = 6%

Calculation:-

Effective interest amount=Interest + Transaction fee

                                            = (0.055 ×$8,800) + $44= $528.00

Effective rate of interest =(Interest cost / Principal) ×(Days per year / Days loan is outstanding)

=($528.00 / $8,800)×(360 / 360)

=.0600, or 6.00%

Hence the effective interest rate = 6.00%

b)The LIBOR rate loan has effective rate of 6 percent which is cheaper than the prime rate loan at 7 percent. Hence the LIBOR rate will have lower effective interest cost.

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