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
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 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.
