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Definition

Compensating Balance

What is Compensating Balance? 

A Compensating Balance is a set amount of money that borrowers hold in their joint bank accounts with the lender. It is a required minimum amount of funds that a firm receiving a bank loan must keep in a checking account at the lending bank. Because the lender can deposit the funds in the compensatory checking account and retain some or all of the earnings, this amount aims to lower the lender's loan costs. 

Understanding Compensating Balance

The borrower could also gain from a cheaper interest once an income is offered. However, the practical outcome interest rate is significantly higher because the borrower is also making payments on a net loan amount that is less than the amount borrowed.

The borrower agreeing to retain a compensatory balance guarantees the lender that the account will be kept minimum. However, the bank is free to apply the offsetting amount to other borrowers' debts. The compensated balance is often stated as a percentage of the borrowed amount. 

The money is usually kept in a bank deposit, such as a checking or savings account, a fixed deposit, or another type of retaining account. It is a good thing overall for the borrower. The loan will usually have a lower rate of return. However, the borrower is responsible for paying interest on the balance, including any outstanding loan, according to the borrowing agreement. 

A compensating balance loan can be given to a person or an organization with a bad credit score. Those who do not qualify for a loan may face higher interest rates or be denied a loan.

Practical Example

A bank has extended a $10 million line of credit to a company. The company must have a compensatory amount of at least $1 million in a bank account, according to the borrowing agreement. Once the two sides of the deal are added together, the loan totals $9 million. 

In Sentences

  • Generally, material compensating balances should report separately from ordinary cash balances.

 

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