When a bank issues you a compensating balance loan, it requires that you maintain a bank account there with a minimum balance. This serves as a kind of collateral and can result in a lower interest rate. However, the effective interest rate on a loan with a compensating balance is actually higher than a balance-free loan.
In most cases, if you're taking out a compensating balance loan, it's a compensating balance and installment loan. Most lending in the United States takes the form of installment loans. A mortgage or car loan, for example, pays you a lump sum up front, and then you pay the money back in regular installments.
If you're not taking out an installment loan, you'll have to pay the loan back in a lump sum. Such loans usually come from people from whom you buy goods or services. For example, if a supplier lets you buy on credit, the supplier is technically loaning you money until you pay off the bill. It's unlikely you'll have a compensating balance.
A bank may also require you to deposit a compensating balance if you request a line of credit. Rather than a $20,000 loan, a $20,000 compensating balance line of credit allows you to borrow money from the bank up to that amount whenever you need it. You only pay interest on the money you borrow, though the bank will charge a fee for keeping the line of credit open.
For a compensating balance example, suppose you borrow $150,000 from the bank to invest in new factory equipment. You pay back the loan in monthly installments over the next three years. Part of the loan condition is that you deposit $25,000 in an account at the bank in return for which they cut the interest rate from 6 to 5%.
This works out well for the bank. It has loaned you $150,000, but since it has your $25,000, the loan only ties up $125,000 in bank funds. You get a lower interest rate, which benefits you.
The downside is that your interest payments are based on borrowing $150,000 at 6%. Practically speaking, you're really borrowing $125,000, but you're paying more in interest than if you borrowed $125,000 at 6%.
Borrowing $150,000 at 6% simple interest over one year yields $9,000 in interest over the life of the loan. However, the effective interest rate on a loan with a compensating balance is actually higher. You're paying $9,000, but after you subtract the $25,000, you're paying the interest on only $125,000.
How much is your effective interest rate? It's simple to calculate. Subtract the compensating balance from the loan amount and then divide the result into your total interest.
In the current compensating balance example, for instance, you subtract $25,000 from $150,000, giving you $125,000. Dividing the $9,000 total interest by $125,000 gives you .072. Your effective interest rate is 7.2%.
A compensating balance line of credit and a loan usually serve two different purposes. When a business applies for a loan, it's usually for a specific expense, such as buying equipment or buying a truck. A compensating balance line of credit is more open ended.
For example, you might take out a $5,000 loan to cover the purchase of new computers and graphic design software. A $5,000 line of credit is a hedge against the future. You don't know for what you might need to borrow money, but when the time comes, you'll have it waiting, having already filled out the relevant paperwork.
Loans usually work better for major expenses you want to pay back over several years. Lines of credit give you more flexibility in tapping the money. With a compensating balance line of credit, however, you'll have to commit a balance to the bank before you even draw on any of the money, and that may be a drawback depending on your financial situation.