A borrower has two alternatives for a loan: (1) issue a $240,000, 60-day, 8% note or (2) issue a $240,000, 60-day note that the creditor discounts at 8%.
a. Calculate the amount of the interest expense for each option.
b. Determine the proceeds received by the borrower in each situation.
c. Which alternative is more favorable to the borrower? Explain.
Answer:
a. $240,000 × 8% × 60/360 = $3,200 for each alternative.
b.
(1) $240,000 simple-interest note: $240,000 proceeds
(2) $240,000 discounted note: $240,000 – $3,200 interest = $236,800 proceeds
c. Alternative (1) is more favorable to the borrower. This can be verified by
comparing the effective interest rates for each loan as follows:
Situation (1): 8% effective interest rate
($3,200 × 360/60) ÷ $240,000 = 8%
Situation (2): 8.11% effective interest rate
($3,200 × 360/60) ÷ $236,800 = 8.11%
The effective interest rate is higher for the discounted note because the creditor lent only $236,800 in return for $3,200 interest over 60 days. In the undiscounted note, the creditor must lend $240,000 for 60 days to earn the same $3,200 interest.