Wooster Company, a manufacturer of athletic apparel, wants to borrow $10,000 at a stated annual rate of 10% interest for 1 year. If the interest on the loan is paid at maturity, the firm will pay $1,000 (0.10 $10,000) for the use of the $10,000 for the year. Substituting into Equation 15.3 reveals that the effective annual rate is therefore
If the money is borrowed at the same stated annual rate for 1 year but interest is paid in advance, the firm still pays $1,000 in interest, but it receives only $9,000 ($10,000 $1,000). The effective annual rate in this case is
Paying interest in advance thus makes the effective annual rate (11.1%) greater than the stated annual rate (10.0%).
Equation 15.3
