compensating balance
A business owner reviews a loan agreement that includes a compensating balance requirement.
Noun: A compensating balance is a minimum deposit amount that a bank requires a borrower to maintain in an account as a condition for obtaining or keeping a loan or a line of credit. This balance, which the borrower cannot use, effectively reduces the net amount of funds available from the loan, thereby increasing the loan's effective cost for the borrower.
This term is used primarily in banking and corporate finance contexts. It describes a specific requirement in a lending agreement. - The bank approved the line of credit with a 10% compensating balance requirement. - To secure the loan, the company must keep a compensating balance of $50,000 in its checking account.
- The small business found the compensating balance requirement restrictive, as it tied up capital that could be used for operations.
- When calculating the true cost of the loan, the finance manager included the impact of the compensating balance.
- The loan agreement stipulates a compensating balance equal to 5% of the credit line.
- Economic Effect: A compensating balance increases the effective interest rate. For example, if a company borrows $100,000 at 5% nominal interest but must keep a $10,000 compensating balance, it only has use of $90,000. The interest paid is still $5,000 (5% of $100,000), making the effective interest rate on the usable funds approximately 5.56% ($5,000 / $90,000).
- Negotiation Point: In commercial lending, the size of the compensating balance is often a negotiable term between the bank and the borrower.
- Balance: The amount of money in an account.
- Minimum Balance: The lowest amount that must be kept in an account to avoid fees or maintain account status. (Note: A is a specific type of minimum balance required for a loan.)
- Loan Covenant: A condition in a loan agreement. A compensating balance requirement is one type of covenant.
- Offsetting balance
- Compensatory balance
- Effective Interest Rate: The real cost of a loan, which accounts for fees, compounding periods, and requirements like a compensating balance.
- Line of Credit: A flexible loan arrangement from a bank, often subject to a compensating balance requirement.
- Collateral: An asset pledged to secure a loan. A compensating balance acts as a form of cash collateral.
A business owner reviews a loan agreement that includes a compensating balance requirement.
- a minimum credit balance that a bank may require a borrower to keep on deposit as a condition for granting a loan; a common requirement for establishing a line of credit at a bank
- the compensating balance increases the effective interest rate to the bank since the net amount loaned is reduced but the interest paid is unchanged