**Small Business Taxes & Management ^{TM}**

The stated interest rate frequently does not reflect the true cost of a business loan. The loan agreement may specify that you maintain compensating balances, pay a commitment fee or the loan may be discounted. These are the more frequently encountered terms.

When a loan is discounted the interest is subtracted from the total amount of the loan. Thus, the proceeds you receive, and have the use of, represent the difference between the face amount of the loan and the stated interest. Discounted loans are usually short-term loans.

For example, assume the stated interest rate on the loan is 12%, the face amount of the loan is $100,000 and the term is one year. The total interest (12% of $100,000 for one year) is $12,000. Since the interest is paid up front, subtracting this from the face amount yields $88,000 of funds available for use. The effective interest rate is computed:

Interest/Net proceeds = Effective interest rateIf the maturity of the loan is less than a full year, you must make an adjustment for the shorter term.$12,000/$88,000 = 13.64%

Compensating balances are similar in that the bank requires you to leave a portion of the loan in the bank, effectively reducing the amount of funds available for your use. You, of course, pay interest on the entire loan.

Assume a $100,000 loan, term of one year, interest rate of 12%. The compensating balance requirement is 15% of the loan. Thus, while you're borrowing and paying interest on $100,000, the amount available for your use is only $85,000 ($100,000 less 15% of $100,000). The effective interest rate is computed:

Interest/Net proceeds = Effective interest rateYou could have a loan subject to both requirements, that is, the loan could be both discounted and compensating balances required. Using the numbers in the two examples above, in that case the funds available would be reduced by the $12,000 interest paid up front and the $15,000 compensating balance. The formula is the same, but the net proceeds available are only $73,000 ($100,000 less $12,000 up-front interest payment less $15,000 compensating balance). Dividing the $12,000 interest by the $73,000 in proceeds results in an effective interest rate of 16.44%.$12,000/$85,000 = 14.12%

In some cases a commitment fee is charged. This is to compensate the bank for standing by and having the money available to loan to you. Typically the fee may be 1% of the amount not taken down. For example, you think you may need as much as $100,000 during the coming year. Currently, however, you only need $70,000. If you borrow the full $100,000 you'll pay 12% interest on the total. If you borrow only $70,000 the interest will be $8,400 (12% of $70,000). However, you'll have to pay a 1% commitment fee on the $30,000 not taken down. In effect that's a $300 annual charge for the right to borrow an additional $30,000. To compute the true interest rate on the amount borrowed ($70,000) you have to add the commitment fee to the interest charge and subtract the fee from the loan proceeds (since the fee is paid up front). Thus, the effective interest rate is computed:

(Interest cost + Commitment fee)/(Amount drawn down - Commitment fee) = Effective interest rateThe commitment fee can be assessed in combination with either a discounted loan and/or a compensating balance requirement. When calculating the combined effect of these terms remember to reduce the amount of the loan proceeds available for your use and increase the interest cost by the amount of any special charges.($8,400 + $300)/($70,000 - $300) = 12.48%

Copyright 2012 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536

**--Last Update 08/31/12**