Compensating balances

Definition

A compensating balance is a minimum balance that a borrower must maintain in a bank account as part of the terms of a loan agreement. This balance acts as collateral and can affect the effective interest rate on the loan.

5 Must Know Facts For Your Next Test

1. Compensating balances are used by banks to reduce lending risk.
2. The required balance is usually a percentage of the loan amount.
3. These balances are typically non-interest-bearing accounts.
4. Compensating balances can increase the effective cost of borrowing.
5. They are commonly associated with business loans and lines of credit.

Review Questions

• What is the primary purpose of a compensating balance?
• How does maintaining a compensating balance affect the effective interest rate on a loan?
• Are compensating balances generally held in interest-bearing or non-interest-bearing accounts?

Related terms

Trade Credit:

Short-term credit extended by suppliers to allow businesses to buy now and pay later.

Working Capital:

The difference between current assets and current liabilities, indicating liquidity.

Cash Management:

The process of collecting, managing, and investing cash in an organization.