Question

Mark McClennan signed a simple discount note for $2,950 for 100 days at a rate of 8.5%.

Find the effective interest rate based on the proceeds received by McClennan.


8.8%

8.5%

8.6%

8.7%

Answer 1

To get the effective interest rate (EIR) of the loan, determine first whether we will use a simple interest method or a discounted method. In this case, we will use a discounted method because the loan is a discounted one. In a discounted method, interest is deducted from the loan principal. So the formula will look like this:

EIR = Interest ÷ (Principal - Interest)

Before proceeding any further, solve first for interest. (assuming a 360-day year)
Interest = Principal × rate × interest
= $2950 × (100/360) × (0.085)
= $69.65

Thus, EIR can be computed as follows:
EIR = ($69.65 ÷ ($2950 - $69.65)) × 360
≈ 8.7%

Notice that the EIR was multiplied by 360 to return it to an annual rate.