A compensating balance compensates a financial institution
Compensating balance is a balance that must be held with a lender in order for a borrower to be eligible for an installment loan or line of credit. Show
Compensating balance is a balance that must be held with a lender in order for a borrower to be eligible for an installment loan or line of credit. Let’s take a closer look at what a compensating balance is and how it works, so you can understand how it may apply to your situation. Definition and Example of a Compensating BalanceThe balance you agree to maintain with a lender as a borrower is known as a compensating balance. It’s intended to reduce the cost of lending for the lender because it allows them to invest the cash in the compensating balance account and keep all or a portion of the proceeds. A compensating balance may also benefit you as a borrower because you’ll likely be able to secure a lower interest rate. Let’s say you’re a small business owner. You want to borrow a $50,000 line of credit. ABC Bank offers you a $70,000 line of credit with a $10,000 compensating balance. In this situation, you’ll be on the hook for that $10,000 each month, whether you access the line of credit or not. If you do withdraw funds from the line of credit, you’ll be responsible for the interest on what you borrow plus the $10,000 compensating balance.
NoteA compensating balance acts as collateral for the lender, allowing them to take on less risk when lending money. How a Compensating Balance WorksOften, you’re forced to accept a compensating balance as a borrower. Maybe you’re a new small business and don’t have a credit history, so this is your only option. Perhaps an offer with a compensating balance provides you with an overall better deal. A compensated balance is usually kept in a deposit account, such as a checking or savings account or a certificate of deposit (CD). It can be calculated in two ways: as an average balance arrangement or a minimum fixed balance arrangement. While the average balance is common with installment loans, the minimum fixed balance is widely seen with lines of credit. If your agreement has an average balance agreement, you must maintain a minimum average balance over an agreed-upon term, which is typically 30 days. With a minimum fixed balance, you’ll be required to always keep an agreed minimum balance with the lender. 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. Also, when you take out a loan with a compensating balance, you must report the balance as “restricted cash” in your financial statements. Restricted cash refers to money that is reserved for a specific purpose and not available for general or immediate business use. Pros and Cons of a Compensating BalancePros
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Pros Explained
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Key Takeaways
Was this page helpful? Thanks for your feedback! Tell us why! Other SubmitSources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. What is a compensating balance?Definition. Compensating balance is a balance that must be held with a lender in order for a borrower to be eligible for an installment loan or line of credit.
What is a compensating balance quizlet?A compensating balance is a minimum balance that must be maintained in a bank account, and the compensating balance is used to offset the cost incurred by a bank to set up a business loan.
What is the effect of compensating balance?A compensating balance is a minimum bank account balance that a borrower agrees to maintain with a lender. 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.
Is compensating balance considered cash?Compensating balances are considered restricted cash and must be reported on a company's financial statement.
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