Question

17

Dr. Ruth is going to borrow $7,200 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 12 percent and LIBOR 2.5 percent less. Also assume there will be a $45 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.) Effective interest rate % b. Which loan has the lower effective interest cost? LIBOR Prime

Answer 1

Solution :

Prime rate loan - 12%

LIBOR rate loan

Effective rate of interest = ( 9.5 % * $7,200 ) + $45 = $684 + $45 = $729

= $729 / $7200 = 10.125% ~ 10.13%

b) LIBOR

LIBOR rate is cheaper than prime rate . ( 10.13% < 12%)

Answer 2

SOLUTION :

a.

LIBOR LOAN :

Interest rate = 12 - 2.5 = 9.5 % = 0.095

Loan is for one year.

=> Loan interest cost = 7200 * 0.095 + 45 = 729 ($)

Effective rate

= 729/7200

= 0.1013

= 10.13 % (ANSWER).

 

b.

Effective interest cost on prime rate = 7200*0.12 = 864 ($)

Effective interest cost on LIBOR loan = 729 ($) 

LIBOR loan has the lower effective interest cost. (ANSWER)