The borrower must keep an agreed minimum balance with the lender at all times. 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. A borrower who has entered into a compensating balance arrangement may need to disclose this situation in the footnotes to its financial statements, if the amount is material. This is not necessary when the financials are only being distributed internally, to the management team.
The compensating balance purpose is to ensure some level of liquidity for the lender in case the borrower defaults. A compensating balance acts as collateral for the lender, allowing them to take on less risk when lending money. Assume, for example, the interest rate on the LOC is an annualized rate of 6% and the store starts the month with a $20,000 cash balance.
Pros and cons of compensating balances
Smith’s Bank offers to provide a £110K line of credit with a £10K compensating balance on the average balance arrangement. Hotshot Fashions, therefore, has to pay interest on £10K each month, regardless of whether or not it accesses the line of credit. If it does access the line of credit it pays interest on what it borrows plus the £10K compensating balance. This can help you better understand things like loan balance, any administrative costs and the overall cost of borrowing. You won’t get hit with any sudden surprises or fees you weren’t expecting. Plus, you can receive cash balances that fit with what you need, all while staying within the accounting rules.
There can be any number of reasons for you to take out a loan or get a line of credit. The compensating balance cuts down on the risk to the lender by allowing for recovery of part of the loan in cases of default. Even though the company has access to only $80,000, it must pay interest on the full $100,000 loan amount.
Basically, it’s a balance agreement that acts as collateral for the lender which helps avoid insufficient balances. As an example of a compensating balance arrangement, a corporation has a $5 million line of credit with a bank. The borrowing agreement states that the corporation will maintain a compensating balance in an account at the bank of at least $250,000.
You would still pay interest each month on your compensating balance of $10,000. But, if you do use your line of credit, you then pay interest on whatever amount you borrow, plus the compensating balance. Primarily, a compensating balance helps safeguard the lender while providing the borrower with access to necessary funds.
An example of a compensating balance arrangement
Perhaps an offer with a compensating balance provides you with an overall better deal. This restriction means the funds aren’t fully liquid, which can affect the company’s ability to quickly access cash. To fully understand the impact of this arrangement, you can apply the compensating balance formula to calculate the effective interest rate. It’s not uncommon for borrowers to commit to a compensating balance without knowing it. Before you take out a loan, be sure to read the fine print and find out whether you’ll be responsible for a compensating balance.
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A compensating balance is a specific amount of money that a borrower is required to keep in a bank account as part of a loan agreement. By holding this balance, the lender ensures that they have some funds on hand if the borrower faces difficulties in repaying the loan. This balance is not just a formality—it serves as collateral, giving the lender more confidence in the loan’s security. In addition to loans, a compensating balance approach may be used to secure a line of credit. 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. The average balance arrangement requires a borrower to ensure that they maintain a minimum average balance over an agreed period.
The requirement for a compensating balance is most common with corporate rather than individual loans. The borrower cannot use the money but is required to disclose it in the borrower’s notes attached to its financial statements. The minimum fixed balance arrangement is exactly what it sounds like.
- The requirement for a compensating balance is most common with corporate rather than individual loans.
- A compensating balance allows lenders to limit that risk and receive collateral in case something happens.
- They must, however, ensure that the money is repaid within the agreed time frame.
- The borrower who agrees to hold a compensating balance promises the lender to maintain a minimum balance in an account.
- But in some instances, you might even decide to agree to a compensating balance on your own.
The bank instead offers you a line of credit for $60,000, which includes a $10,000 compensating balance. If a compensating balance is not explicitly mentioned or is “silent” in the loan agreement, it can lead to ambiguity and potential disputes between the borrower and the lender. In such cases, the borrower might not be aware of the requirement to maintain a specific balance, which could lead to unexpected financial obligations or penalties. It’s crucial for both parties to clearly define and understand all terms in the loan agreement to avoid misunderstandings.
Hotshot Fashions, therefore, has to pay interest on a £110K loan to get the £100K loan it actually needs. Some borrowers may agree to leave a compensating balance because it provides them with a better overall deal. In short, even though they have to pay interest on the compensating balance, the lower interest rate they receive makes this worthwhile. A compensating balance effectively changes the risk versus reward balance in favour of the lender. The lender pays a reduced amount to the borrower, but receives interest on the full amount of the loan. A compensating balance allows lenders to limit that risk and receive collateral in case something happens.
What Is a Compensating Balance?
Effectively it acts as collateral and thus compensates the lender for the risk of making the loan. The most common structure for a compensating balance is very simple. By the time the credit line is accessed turbotax advantage, sign in to manage your advantage account and drawn on, the balance in the compensating account will be $15,000.00 USD. Your business is looking to take out a line of credit for the amount of $50,000.
The former tends to be used for lines of credit and the latter for instalment loans. A bank account balance that a corporation agrees to maintain with a current or potential lender. At a minimum, compensating balances must be disclosed in the notes to the corporation’s financial statements.
The purpose of this balance is to reduce the lending cost for the lender, since the lender can invest the cash located in the compensating bank account and keep some or all of the proceeds. The borrower may also benefit from being granted a somewhat lower interest rate. An average balance arrangement is usually used for lines of credit. A minimum fixed balance arrangement tends to be more common for things like instalment loans. There are two main ways of calculating a compensating balance. These are the average balance arrangement and the minimum fixed balance arrangement.
Just like your individual credit, you also need to build up a solid credit history with your business. Having a poor credit rating can lead to a lending cost that isn’t ideal. But in some instances, you might even decide to agree to a compensating balance on your own. If you want to take out a loan or qualify for apb meaning a line of credit, there are obligations for you to meet. A compensating balance is a certain balance that you need to keep to qualify for instalment loans or a line of credit.