Compensating Balance
What is a Compensating Balance?
Compensating balance : It is an amount of cash offered by the company or withheld from a loan given to the company that reserved by a financial institution (bank), to compensate the bank for services rendered to the company.
A compensating balance may be required by a covenant in a loan agreement that requires a company to maintain a minimum specified balance in checking account during the term of the loan.
Example of a Compensating Balance
A bank approved a loan of $100,000 (10%) with $20,000 compensating balance. This means that company only can receive $80,000 but the 10% interest would be paid on the $100,000 thus compensating, balance raises effective interest rate :
| Effective interest rate = | $100,000 × 10% | = 0.125 | = 12.5% |
| $80,000 |
The previous example represents a screw account where no interest is paid on compensating balance.
If the compensating balance could earn – A low interest rate – say ⇒ 3%
| Effective interest rate = | $100,000 × 10% – $20,000 × 3% | = 0.1175 | = 11.75% |
| $80,000 |