In this example, the compensating balance serves as a risk mitigation tool for XYZ Bank, ensuring that ABC Company maintains a certain level of liquidity. At the same time, it increases the borrowing cost for ABC Company, as the company has limited access to the full loan amount and cannot earn interest on the compensating balance. As a part of the loan agreement, the bank requires ABC Company to maintain a compensating balance of 10% of the loan amount in a non-interest-bearing account at the bank. A compensating balances plan essentially serves as a savings account funded through the insurance policy for the business.
Can compensating balances affect credit scores?
The borrower may also benefit from being granted a somewhat lower interest rate. Compensating balances are less common for personal accounts compared to business personal and business banking twin cities accounts. However, some banks may impose minimum balance requirements or offer preferential terms for certain services based on maintaining a minimum balance.
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One has no compensating balance requirement, but the other calls for $200,000 to be left on deposit at all times. 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.
Understanding a Compensating Balances Plan
For the borrower, this extra $20,000 reduces the interest rate they can get on this loan. However, they also have to bear extra interest on the additional $20,000 balance. 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.
What is the Accounting for a Compensating Balance for the Borrower?
A 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. If a customer fails to maintain the required compensating balance, they may be subject to penalties or fees, and the bank may restrict access to certain services or even close the account. No, compensating balances are not always required, but banks commonly use them, especially for business accounts or larger transactions. They frequently appear in lines of credit, offering borrowers flexibility while protecting the lender. The minimum balance acts as a guarantee, ensuring funds are readily available to cover withdrawals within the credit limit.
Or are you just now looking into what some of your options are and came across a few terms you aren’t familiar with? There can be any number of reasons for you to take out a loan or get a line of credit. Emily is a real estate developer seeking to borrow $10 million to finance the construction of a new condominium tower. She approaches a commercial bank that agrees to finance her project under terms that include a twenty percent rule. Charlene Rhinehart is a CPA , CFE, chair of an Illinois CPA Society committee, and has a degree in accounting and finance from DePaul University. Once you have viewed this piece of content, to ensure you can access the content most relevant to you, please confirm your territory.
Restricted Cash FAQs
Plus, you can receive cash balances that fit with what you need, all while staying within the accounting rules. 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. The store plans to use the LOC to purchase inventory at the beginning of the month, and then pay down the balance with money brought in by sales throughout the month. Compensating balances are generally reported on financial statements as restricted cash. Restricted cash is money that is allocated for a set purpose and is thus not available for immediate or general business use. Discover the meaning of a compensating balances plan in finance and how it can impact your financial strategy.
- Restricted cash may be counted as collateral if both the cash balance is segregated and it has some level of enforceability.
- Once the LOC is in place, the clothing store needs to manage cash flow so the business can minimize the interest expense paid on the LOC borrowings.
- The most common structure for a compensating balance is very simple.
If the compensating balance is not legally enforceable (the creditor can terminate it at will), then footnote disclosure is required (like any other non-enforceable agreement). The volume and dollar amounts of compensating balances are, by themselves, immaterial and require no additional footnote disclosure (if they result in increased effective rates). The average balance arrangement requires a borrower to ensure that they maintain a minimum average balance over an agreed period.
Remember, knowledge is power, especially when it comes to your finances. Compensating balances can take the form of cash held in deposit accounts, securities such as stocks or bonds, or other assets agreed upon by the bank and the customer. Banks assess a borrower’s creditworthiness, profitability, and cash flow stability. A borrower with a strong financial track record and healthy cash reserves might qualify for a lower compensating balance than one with weaker financials.
The borrower who agrees to hold a compensating balance promises the lender to maintain a minimum balance in an account. The bank is free https://www.adprun.net/ to use the compensating balance in loans made to other borrowers. The minimum fixed balance arrangement is exactly what it sounds like.
It’s a way for lenders to build loyalty and encourage continued business. This requirement, essentially a minimum deposit the borrower maintains, can seem perplexing. Why, when you’re borrowing money, do you need to keep some of it locked away? Understanding the seven key reasons lenders utilize compensating balances can illuminate this financial dance. 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.
While they cannot use this money, it reduces their effective borrowing rate to 4% ($5,000 interest / $800,000 available funds). For some borrowers, particularly large corporations with complex financial operations, the convenience and efficiency offered by a compensating balance can be a significant draw. Many lenders allow for automated sweeps, seamlessly maintaining the minimum balance by transferring excess funds from other accounts as needed. This eliminates manual monitoring and ensures compliance, streamlining financial processes and saving valuable time and resources.
The borrower ends up receiving a reduced amount from the lender, but the lender still receives interest on the full amount of the loan. Under the terms of her loan, Emily is required to deposit $2 million from the $10 million loan into a non-interest-bearing account held at the lending bank. The bank is then free to invest or lend those funds without paying Emily any interest on her deposit. In finance, the twenty percent rule is a convention used by banks in relation to their credit management practices. Specifically, it stipulates that debtors must maintain bank deposits that are equal to at least 20% of their outstanding loans.
Smith’s Bank offers to lend them £110K with a £10K minimum fixed compensating balance. Hotshot Fashions, therefore, has to pay interest on a £110K loan to get the £100K loan it actually needs. Smith’s Bank offers to lend them $110K with a $10K minimum fixed compensating balance. Hotshot Fashions, therefore, has to pay interest on a $110K loan to get the $100K loan it actually needs. 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.
This opens doors for those who may not have readily available assets to pledge, making loan accessibility more inclusive. Its flexibility can be a game-changer for businesses seeking to expand or individuals pursuing personal goals. New businesses and individuals with limited credit histories often face challenges securing loans.
This restricted cash can also be used to make new loans, increasing the lender’s earning potential. This method provides some flexibility for borrowers, as they can adjust their balance levels throughout the period as long as the average meets the specified threshold. However, it also requires diligent monitoring to ensure compliance and avoid penalties.