Loan with Compensating Balance
A compensating balance is a balance that must be kept with a lender in order for a borrower to qualify for a line of credit or instalment loan. Effectively it acts as collateral and thus compensates the lender for the risk of making the loan.
What is an example of compensating balance?
Example of a Compensating Balance
A corporation has a $5 million line of credit with a bank. The borrowing agreement states that the corporation will maintain a compensating balance in an account at the bank of at least $250,000. When the two sides of the arrangement are netted, the loan is actually $4,750,000.
What is a compensating balance and what is its purpose?
Compensating balance is the least or minimum balance that an organization or an individual needs to keep with the lender. The primary objective of such a balance is to reduce the lending cost of a borrower. For instance, a company takes a loan of $50,000 from a bank and agrees never to use $5,000.
How do I calculate my compensating balance loan?
Example: Assume the interest rate on a compensatory balance loan has an interest rate of 5 percent, a principal of $100,000, and a compensatory balance of $5,000. Effective interest rate = $5,000/($100,000 – $95,000) = $5,000/$95,000 = 0.0526 = 5.26 percent.
What effect does a compensating balance requirement have on the effective interest rate on loan?
Compensating balances also decrease the proceeds of the loan. As proceeds decline, the effective interest rate rises. Example: You borrow $ 30,000 at 12%. The Bank requires that you maintain a 10% compensating balance.
Why might the bank require a compensating balance?
Agreeing to a compensating balance allows a company to borrow money at a favorable rate of interest. The compensating balance offsets the bank’s default risk and can be used to make new loans. The business borrower must report the compensating balance in its financial statements, typically as restricted cash.
Is compensating balance considered cash?
Compensating balances are considered restricted cash and must be reported on a company’s financial statement.
What advantages do compensating balances have for banks are the advantages to banks necessarily disadvantages to corporate borrowers?
What advantages do compensating balances have for banks? The use of a compensating balance or minimum required account balance allows the banker to generate a higher return on a loan because not all funds are actually made available to the borrower.
What is a compensating balance how do we classify such account in relation to the loan for which it serves as a collateral?
A compensating balance is a balance that must be kept with a lender in order for a borrower to qualify for a line of credit or instalment loan. Effectively it acts as collateral and thus compensates the lender for the risk of making the loan.
Which of the following correctly describes compensating balance?
Which of the following describe compensating balances? Compensating balances are a specified balance a borrower of a loan is asked to maintain in a low-interest or noninterest-bearing account at the bank.
Which of the following is true concerning deposits held as compensating balances?
Which of the following is true concerning deposits held as compensating balances? They may be included as cash if legally restricted and held against short-term credit.
How does a compensating balance requirement in a loan contract benefit a bank?
A compensating balance is a balance that must be kept with a lender in order for a borrower to qualify for a line of credit or instalment loan. Effectively it acts as collateral and thus compensates the lender for the risk of making the loan.
Who has to compensate for an event that was seen as normal in the credit business?
The company is called the reference entity and the default is called credit event. It is a contract between two parties, called protection buyer and protection seller. Under the contract, the protection buyer is compensated for any loss emanating from a credit event in a reference instrument.
What is compensating balance quizlet?
Compensating balances. A compensating balance is a minimum balance that must be maintained in a bank account, and the compensating balance is used to offset the cost incurred by a bank to set up a business loan.
What is compensating balance?
Compensating balances are funds that a borrower is required to keep on deposit in a bank to satisfy the terms of the commercial real estate loan agreement. Depending upon the stipulated agreement, the deposit may be held in a checking account, savings account, or certificate of deposit.
What is a compensating balance chegg?
Compensating balances is defined as the minimum amount which the borrower keeps with the bank. It is pre-requisite for the loan to be granted. Compensating balances are common for corporate loans.