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Consider two loans with​ one-year maturities and identical face​ values: a(n) 8.0 % loan with a 1.00 % loan origination fee and​ a(n) 8.0 % loan with a 5.0 % ​(no-interest) compensating balance requirement. What is the effective annual rate ​(EAR​) associated with each​ loan? Which loan would have the highest EAR and​ why?

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Answer:

EAR in first case 9.08%

Second case 8.42%

Explanation:

EAR in first case = 1.08 * 1.01 = 9.08%

In second case = 8/(1 - 0.05)= 8.42%

The second case has a higher EAR because the fee and interest rate is higher than in the second case.***