Compensating Balance: Definition Explanation Examples

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. Basically, it’s a balance agreement that acts as collateral for the lender which helps avoid insufficient balances.

This is frequently offered by bankers as a way to offer a lower interest rate on loans made to existing bank customers. If the compensating balance falls below the statutory minimum, the interest rate on the loan will increase proportionally. This can help you better understand things like loan balance, any administrative costs and the overall cost of borrowing. You won’t get hit with any sudden surprises or fees you weren’t expecting. Plus, you can receive cash balances that fit with what you need, all while staying within the accounting rules.

What Is Compensating Balance?

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. The bank is free to use the compensating balance in loans made to other borrowers. However, the borrower must pay interest on the full amount of the loan, including the balance that may not be spent. 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.

• When errors have been compensated, the trial balance is in agreement.
• Agreeing to a compensating balance may allow a company to borrow at a favorable rate of interest.
• For the borrower, this extra $20,000 reduces the interest rate they can get on this loan.

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Advantages of a Compensating Balances Plan

Then the excess debit of $500 in the advertising account is set off against the excess credit in the interest account. As the excess debit is compensated with the excess credit, the trial balance does not reveal the errors. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network.

How a Compensating Balance Works

The store estimates sales for the month to be $50,000, and $40,000 in inventory needs to be purchased to meet customer demand. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.

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Then, they will pay down the balance with money brought in by sales throughout the month. The bank agrees to charge a lower interest rate on the LOC if the clothing store maintains a $30,000 compensating balance. The bank then loans the restricted cash balance to other borrowers. As a result, the lender profits on the difference between the interest it earns and the lower rate of interest charged to the furniture store. The dollar amount of a compensating balance can often be significant in corporate accounting.

A compensating balance is an amount that borrowers must maintain in their accounts. While compensating balance requirements may apply to both individuals https://personal-accounting.org/retained-earnings-definition/ and companies, it is most prevalent for companies. Therefore, companies that borrow a loan with a compensating balance must account for it accordingly.

Compensating balance

The term “cumulative error” refers to any error that happens in the same direction during the chaining operation. It is also possible for two or more errors of this kind to be made in the books, which cancel out each other’s effects. Once you have viewed this piece of content, to ensure you can access the content most relevant to you, please confirm your territory. You can set the default content filter to expand search across territories. Joint supply results when multiple products are derived from the same source and at the same expense.