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.
Sometimes referred to as an offsetting balance, the purpose of the compensating balance is to offset the expenses associated with extending and servicing the loan. By allowing the funds to remain in the non-interest bearing account for the duration of the loan, the bank is free to make use of those funds as part of their investment strategies. In this manner, the cost for providing loans is reduced, and both the bank and the borrower benefit from the transaction.
In addition to loans, a compensating balance approach may be used to secure a line of credit. Just as with a loan, the individual or business entity receiving the line of credit must have accounts already in place with the bank, and agree to maintaining a minimum account balance for the loan period. In the event that the balance drops below that minimum, the interest rate is adjusted upward and usually does not drop back down, even if the minimum balance to the account is restored.
The most common structure for a compensating balance is very simple. Known as the 10 and 5 compensating balance, the structure calls for the borrower to have a minimum of ten percent of the extended line of credit in the account at the time credit line is established, and an additional five percent before drawing against the credit line. This means that if a credit line for $100,000.00 US Dollars (USD) is established, the borrower will have a minimum balance of $10,000.00 USD in his or her account at the time of the credit line commitment. By the time the credit line is accessed and drawn on, the balance in the compensating account will be $15,000.00 USD.