Compensating balance meaning

Compensating balance definitions

When businesses require financing from a bank, they may encounter the concept of a compensating balance. Compensating balance is an amount that a business must maintain in its bank account in order to offset the costs or fees associated with the loan or other financial services provided by the bank. This practice helps banks minimize their risk and ensure that they are able to recover some of the costs associated with providing the loan.

How Compensating Balance Works

Typically, a bank will require a business to maintain a certain percentage of the loan amount in their account as a compensating balance. For example, if a business takes out a loan for $100,000 and the bank requires a 10% compensating balance, the business would need to keep $10,000 in their account at all times. This amount is separate from any payments made towards the loan principal or interest.

Benefits and Drawbacks

One of the benefits of a compensating balance is that it can help businesses secure financing that they may not otherwise qualify for. By maintaining a certain balance in their account, businesses can demonstrate their ability to repay the loan and reduce the bank's risk. However, the main drawback is that the business may have limited access to these funds, as they are essentially locked up as collateral for the loan.

Types of Compensating Balances

There are different types of compensating balances that banks may require, including minimum balance requirements, average balance requirements, and transactional balance requirements. These balances can be calculated based on a percentage of the loan amount, a set dollar amount, or a combination of the two.

In conclusion, a compensating balance is an important concept for businesses to understand when seeking financing from a bank. By maintaining a certain amount in their account, businesses can access the funding they need while also helping banks manage their risk. It's essential for businesses to carefully review the terms and conditions associated with compensating balances to ensure they align with their financial goals.

Compensating balance Examples

1. The bank required a compensating balance of $10,000 to be kept in the account.
2. The business had to maintain a compensating balance in order to receive a loan with favorable terms.
3. The company agreed to hold a compensating balance as part of their agreement with the lender.
4. The merchant was able to negotiate a lower compensating balance in exchange for a higher interest rate.
5. The compensating balance requirement was a key factor in the company's decision to seek financing elsewhere.
6. The compensating balance provision was outlined in the loan agreement signed by both parties.
7. The bank waived the compensating balance requirement for long-time customers with a strong credit history.
8. The compensating balance acted as a form of collateral for the lender in case of default.
9. The business struggled to meet the compensating balance requirement due to cash flow issues.
10. The compensating balance policy varied between financial institutions and loan products.

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