What Is a Compensating Balance?

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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.

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 Balance

The 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.

  • Alternate name: Offsetting balance

A compensating balance acts as collateral for the lender, allowing them to take on less risk when lending money.

How a Compensating Balance Works

Often, 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 Balance

Pros
  • Lower interest rate

  • Chance to qualify for financing

Cons
  • Must pay interest on the full loan amount

  • Can lead to debt

Pros Explained

  • Lower interest rate: Depending on the lender, you might be able to lock in a lower interest rate with a compensating balance loan or line of credit. This can be a plus if you’re used to higher rates.
  • Chance to qualify for financing: If you’re a new business owner or have a poor credit score, you may be turned down for other loans. Since a loan with a compensating balance is less risky for a lender, you might get approved for one and secure the financing you need.

Cons Explained

  • Must pay interest on the full loan amount: Even though you might land a lower interest rate on a loan with a compensating balance, you’ll be required to pay interest on the entire amount of the loan. This will be the case even if you don’t ever spend the compensating balance.
  • Can lead to debt: The fact that you’ll have to cover the interest on the full loan amount can steer you into a cycle of debt. This is particularly true if you’re a startup or newer business without a lot of cash at your disposal.

Key Takeaways

  • A compensating balance is the balance a borrower must keep with a lender, usually when taking out an installment loan or line of credit for their business.
  • The primary goal of a compensating balance is to reduce the lender’s expenses of extending and servicing the loan.
  • If you take out a loan with a compensating balance, you’ll have to pay interest on the entire loan amount, even if you don’t use the compensating balance.

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