What Is Compensating Balance Definition

A compensatory balance is an amount that borrowers must hold in their accounts. However, you cannot use this amount. While compensation requirements may apply to individuals and businesses, they are more common for businesses. Therefore, companies that take out a loan with a balancing balance should take this into account accordingly. Offsetting balances are generally recognized as restricted cash in the financial statements. Restricted money is money that is allocated for a specific purpose and is therefore not available for immediate or general commercial use. Some borrowers may agree to leave a compensatory balance because it gives them a better overall deal. In short, although they have to pay interest on the balancing balance, it is worth it because of the lower interest rate. ABC has a $100,000 million loan from Bank A. The terms of the loan include an interest rate of 5% and a settlement balance of $10,000. The borrower must keep this amount in a non-interest-bearing account with the same bank. Since the store requires the cash balance of $20,000 for other expenses, the owner borrows $40,000 from the LOC to purchase inventory.

Most customers pay in cash or with a credit card, so the LOC can usually be paid in the last week of the month. A compensatory balance is a minimum deposit that must be held by a borrower in a bank account. Accepting a compensatory balance can allow a company to borrow at a favorable interest rate. Hotshot Fashions requires a line of credit of $100,000. Smith`s Bank offers to provide a line of credit of $110,000 with a compensation balance of $10,000 for the average balance agreement. Hotshot Fashions must pay interest of $10,000 each month, whether or not it accesses the line of credit. When he accesses the line of credit, he pays interest on what he borrows, plus the balance of the $10,000 in compensation. Such a requirement is a common phenomenon in business loans. The need to maintain the balance may be in a savings account, certificate of deposit or current account, depending on the terms of the contract. The compensatory balance is usually a percentage of the loan amount. Funds are usually held in a deposit account such as a checking or savings account, certificate of deposit (CD) or other deposit account. Restricted cash flow is the one that a company sets aside for a specific purpose.

On the other hand, the compensatory balance is the minimum amount that an organization must keep due to a contractual agreement with the bank. @Babalaas – This creates a difficult choice. A contractor must be able to determine the effective interest rate on both loans before they can determine which loan is a better loan. To determine the effective interest rate of a compensatory balance loan, it is sufficient to divide the interest rate by one minus the balancing balance represented in the form of a decimal balance. To determine the interest rate of a fee-based loan, simply add the costs to the interest as a percentage of the principle. Indeed, with a fee-based loan, the costs are considered part of the interest. A balancing loan with an interest rate of 8% and a remuneration balance of 20% therefore has an effective interest rate of 10% {.08/(1-0.2)=0.10}. If the loan was $100,000, then a 9% loan with $1,300 in fees would have an effective interest rate of 10.3% {0.09+ (1300/10000) = 0.103}.

This would make a $100,000 loan a better solution with the balancing balance. Keep in mind that you can only use $80,000, so the loan you take out should put the compensatory balance into action. A loan with a balancing balance can be granted to an individual or a company with a poor credit rating. These applicants could otherwise be charged higher interest rates or denied a loan. Some borrowers may inadvertently accept a compensatory balance because they have not read or understood their loan agreement. This highlights the importance of making sure you really understand a contract before you sign it. If necessary, ask an expert to explain. The most common structure to compensate for balance is very simple. The structure, known as the balance of 10 and 5 balances, provides that the borrower has at least ten percent of the extended line of credit in the account at the time the line of credit is set up, and another five percent before it is drawn on the line of credit. In other words, if a line of credit of more than $100,000.00 (USD) is set up, the borrower will have a minimum balance of $10,000.00 in their account at the time of the loan commitment.

When the line of credit is viewed and used, the settlement account balance is $15,000.00. The borrower who agrees to hold a settlement balance promises the lender to keep a minimum balance in an account. The bank is free to use the amount of compensation in loans to other borrowers. In principle, compensatory balances should be shown separately from the regular cash balance only if the balance is “substantial”. That is, whether it could affect the judgment of a person who reads the company`s financial statements. For the bank, the additional compensation of $20,000 serves as collateral for the loan. Essentially, the bank still provides $200,000 in the form of a loan. For the borrower, this additional $20,000 reduces the interest rate he can get on this loan.

However, you will also have to pay additional interest on the additional balance of $20,000. This increase can lead to a general increase in the borrower`s costs. A compensatory balance effectively changes the risk-return ratio in favour of the lender. The lender pays a reduced amount to the borrower, but receives interest on the total amount of the loan. @ Glasshouse and Babalaas – You should also consider what the loan is for. If you take out a loan to offset the seller`s debts in order to take out a discount (e.B. 2/10 net 60), it may be interesting to take out the balancing loan. Here`s an example. A offset loan has a balancing balance of 20% and an interest rate of 8%. The discount is 2% if paid in ten days, or none if paid in 60 (2/10 net 60). By inserting 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 were to use any of Glasshouse`s credit scenarios, you would actually earn between 4.39% and 4.69% on the discount. For example, a business has a $5 million line of credit with a bank. The credit agreement states that the Company will maintain a settlement balance in an account with the bank of at least $250,000. If both parts of the agreement are compensated, the loan is actually $4,750,000. An entity may choose to disclose the purpose or purposes of the restricted cash on its main balance sheet. However, it is also perfectly acceptable to include this information in the footnotes. For example, let`s say the interest rate on the LOC is an annualized interest rate of 6% and the store starts the month with a cash balance of $20,000. The store estimates sales for the month at $50,000 and needs to purchase $40,000 in inventory to meet customer demand. The compensatory balance is the least or minimum balance that an organization or individual must hold with the lender. The main purpose of such an equilibrium is to reduce a borrower`s cost of borrowing. For example, a company takes out a $50,000 loan from a bank and agrees never to use $5,000.

This means that the actual loan amount is only $45,000. The balancing balance reduces the risk for the lender by allowing the recovery of part of the loan in the event of default. The fashion company also needs a $100,000 installment loan. Smith`s Bank offers to lend them $110,000 with a fixed settlement balance of at least $10,000. Hotshot Fashions must therefore pay interest on a $110,000 loan to get the $100,000 loan it really needs. A compensatory balance is a loan term that requires borrowers to maintain a certain balance with the lender. This extra balance serves as collateral for the lender and can help borrowers get lower interest rates. However, the borrower cannot access these funds until the loan matures. Borrowers must disclose any balance in their financial statements. Sometimes referred to as the balancing balance, the purpose of the balancing balance is to offset the costs associated with extending and servicing the loan.

By leaving the funds in the non-interest-bearing account for the term of the loan, the Bank is free to use these funds as part of its investment strategies. In this way, the cost of granting loans is reduced and the bank and the borrower benefit from the transaction. The demand for a compensatory balance is more common for business loans and not for individual loans. The borrower may not use the money, but is required to disclose it in the borrower`s notes attached to its financial statements […].