The requirement for a compensating balance is most common with corporate rather than individual loans. The borrower cannot use the money but is required to disclose it in the borrower’s notes attached to its financial statements. The minimum fixed balance arrangement is exactly what it sounds like.
An example of a compensating balance arrangement
The borrower must keep an agreed minimum balance with the lender at all times. Compensating balances are minimum balances that may be maintained in an account and still meet the requirements for a loan. Bankers often offer this as a means of obtaining a more favorable interest rate on loans extended to existing bank customers. In the event that the compensating balance drops below the minimum required, the interest rate applied to the loan will rise accordingly. A the audit committee requirements borrower who has entered into a compensating balance arrangement may need to disclose this situation in the footnotes to its financial statements, if the amount is material. This is not necessary when the financials are only being distributed internally, to the management team.
There can be any number of reasons for you to take out a loan or get a line of credit. The compensating balance cuts down on the risk to the lender by allowing for recovery of part of the loan in cases of default. Even though the company has access to only $80,000, it must pay interest on the full $100,000 loan amount.
Just like your individual credit, you also need to build up a solid credit history with your business. Having a poor credit rating can lead to a lending cost that isn’t ideal. But in some instances, you might even decide to agree to a compensating balance on your own. If you want to take out a loan or qualify for a line of credit, there are obligations for you to meet. A compensating balance is a certain balance that you need to keep to qualify for instalment loans or a line of credit.
What Is a Compensating Balance?
It works the same way if you wanted to take out an instalment loan for the same amount. You would end up paying interest on a $60,000 loan to receive the $50,000 you originally needed. A company may choose to specify the purpose or purposes of the restricted cash in its main balance sheet. It is, however, also perfectly acceptable to include this information as part of the footnotes. 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.
Accounting Rules on Compensating Balances
The purpose of this balance is to reduce the lending cost for the lender, since the lender can invest the cash located in the compensating bank account and keep some or all of the proceeds. The borrower may also benefit from being granted a somewhat lower interest rate. An average balance arrangement is usually used for lines of credit. A minimum fixed balance arrangement tends to be more common for things like instalment loans. There are two main ways of calculating a compensating balance. These are the average balance arrangement and the minimum fixed balance arrangement.
Hotshot Fashions, therefore, has to pay interest on a £110K loan to get the £100K loan it actually needs. Some borrowers may agree to leave a compensating balance because it provides them with a better overall deal. In short, even though they have to pay interest on the compensating balance, the lower interest rate they receive makes this worthwhile. A compensating balance effectively changes the risk versus reward balance in favour of the lender. The lender pays a reduced amount to the borrower, but receives interest on the full amount of the loan. A compensating balance allows lenders to limit that risk and receive collateral in case something happens.
The bank instead offers you a line of credit for $60,000, which includes a $10,000 compensating balance. If a compensating balance is not explicitly mentioned or is “silent” in the loan agreement, it can lead to ambiguity and potential disputes between the borrower and the lender. In such cases, the borrower might not be aware of the requirement to maintain a specific balance, which could lead to unexpected financial obligations or penalties. It’s crucial for both parties to clearly define and understand all terms in the loan agreement to avoid misunderstandings.
Since the store needs the $20,000 cash balance 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 off in the last week of the month. If you’re interested in finding out more about compensating balances, then get in touch with the financial experts at GoCardless. Find out how GoCardless can help you with ad hoc payments or recurring payments. Smith’s Bank offers to lend them £110K with a £10K minimum fixed compensating balance.
The bank agrees to charge a lower interest rate on the LOC if the clothing store deposits a $30,000 compensating balance. A loan with a compensating balance may be extended to an individual or a company with a poor credit rating. Those applicants might otherwise be charged higher interest rates or be turned down for a loan. Businesses have to build up a credit history, just like private individuals. What’s more, it can be set back as a result of both misguided decisions and unforeseen circumstances. But what if you don’t end up using or accessing your line of credit at all?
- Agreeing to a compensating balance may allow a company to borrow at a favorable rate of interest.
- The funds are generally held in a deposit account such as a checking or savings account, a certificate of deposit (CD), or another holding account.
- Plus, you can receive cash balances that fit with what you need, all while staying within the accounting rules.
- Businesses have to build up a credit history, just like private individuals.
- A bank account balance that a corporation agrees to maintain with a current or potential lender.
The store estimates sales for the month to be $50,000, and $40,000 in inventory needs to be purchased to meet customer demand. Once the LOC is in place, the clothing store needs to manage cash flow to minimize the interest expense it’s paying for use of the LOC. For the borrower, the compensating balance is a mixed blessing. However, the borrower must pay interest on the full amount of the loan, including the balance that may not be spent. This is because even though you still need to pay interest on your compensating balance, it might be a lower interest rate. Just make sure that you fully read and understand your contract agreement before signing.
Some borrowers may accidentally end up agreeing to a compensating balance because they did not read, or fully understand their loan agreement. This highlights the importance of making sure that you really understand a contract before you sign it. 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.
To keep things simple, a compensating balance acts as collateral for lenders and helps to compensate for any risks. This allows them to pay out a lower amount, but still receive the full amount of interest on the loan or line of credit. Be sure to check with your bank or lender to see what their self-employed 2020 compensating balance arrangements are. A lot of times as a borrower you’re not going to have a choice.
Effectively it acts as collateral and thus compensates the lender for the risk of making the loan. The most common structure for a compensating balance is very simple. By the time the credit line is accessed and drawn on, the balance in the compensating account will be $15,000.00 USD. Your business is looking to take out a line of credit for the amount of $50,000.
