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Net interest rate is effective interest rate.
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 at12% interest will costs $1,200. The effective interest rate is $1,200 / $10,000 or12%. As we change the costs and/or amount of funds available, the effective interest rate will change.
Example: You borrow $10,000 at12% which is discounted by the Bank at10%, thereby reducing the amount of funds you have available. The effective interest rate is:
$1,200 / $9,000 or13.3%.
Compensating balances also decrease the proceeds of the loan. As proceeds decline, the effective interest rate rises.
Example: You borrow $30,000 at12%. The Bank requires that you maintain a10% compensating balance. The effective interest rate is:
$3,600 / ($30,000 - $3,000) =13.3%.
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