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What is a Compensating Balance?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 22 July 2014
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Compensating balances are minimum balances that may be maintained in an account and still meet the requirements for a loan. Bankers often offer this as a means of obtaining a more favorable interest rate on loans extended to existing bank customers. In the event that the compensating balance drops below the minimum required, the interest rate applied to the loan will rise accordingly.

Sometimes referred to as an offsetting balance, the purpose of the compensating balance is to offset the expenses associated with extending and servicing the loan. By allowing the funds to remain in the non-interest bearing account for the duration of the loan, the bank is free to make use of those funds as part of their investment strategies. In this manner, the cost for providing loans is reduced, and both the bank and the borrower benefit from the transaction.

In addition to loans, a compensating balance approach may be used to secure a line of credit. Just as with a loan, the individual or business entity receiving the line of credit must have accounts already in place with the bank, and agree to maintaining a minimum account balance for the loan period. In the event that the balance drops below that minimum, the interest rate is adjusted upward and usually does not drop back down, even if the minimum balance to the account is restored.

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The most common structure for a compensating balance is very simple. Known as the 10 and 5 compensating balance, the structure calls for the borrower to have a minimum of ten percent of the extended line of credit in the account at the time credit line is established, and an additional five percent before drawing against the credit line. This means that if a credit line for $100,000.00 US Dollars (USD) is established, the borrower will have a minimum balance of $10,000.00 USD in his or her account at the time of the credit line commitment. By the time the credit line is accessed and drawn on, the balance in the compensating account will be $15,000.00 USD.

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Daniel Franks
Post 4

But who will provide a compensating balance loan?

Amphibious54
Post 3

@ Glasshouse and Babalaas - You should also take into account what the loan is for. If you are taking out a loan for clearing accounts payables to take advantage of a cash discount (say a 2/10 net 60), it may be worthwhile to take the compensating loan. Here’s an example. A compensating balance loan has a 20% compensating balance and an 8% rate. The discount would be 2% if paid in ten days or none if paid in 60 (2/10 net 60). By plugging these numbers into the equation I would know that the discount rate would be 14.69% ~(0.02/1.00-0.02)*(360/60-10)=0.1469~. If you used either of Glasshouse’s loan scenarios you would effectively be earning between 4.39% and 4.69% on the discount.

Glasshouse
Post 2

@ Babalaas - This creates a tough choice. A business owner has to be able to determine the effective interest rate for both loans before it can be determined which loan is a better loan. To determine the effective interest rate of a compensating balance loan you just divide the interest rate by one minus the compensating balance represented as a decimal. To determine the rate on a fee added loan you just add the fees as a percentage of the principle to the interest. This is because in a fee added loan, the fees are considered a part of the interest. So a compensating loan with an 8 percent rate and 20% compensating balance has an effective rate of 10% {.08/(1-0.2)=0.10}. If the loan was for $100,000 then a 9% loan with $1,300 in fees would have an effective rate of 10.3% {0.09+(1300/10000)=0.103}. This would make a loan for $100,000 a better deal with the compensating balance. Remember though you can only use $80,000, so the loan you take out should take the compensating balance into affect.

Babalaas
Post 1

In business finances I often hear about fee added loans versus compensating balance loans with no fees. The fee added loan will have administrative fees and a higher interest rate. The compensating balance loan, on the other hand, will have lower rates but a percentage required to be held as a compensating balance. How do I decide which loan is a better deal?

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