A compensating balance is an account balance that a bank can use to offset an unpaid loan. Installment loans featuring a compensating balance requirement will have a higher effective interest rate than loans without this feature. Calculating the interest rate on a compensating balance and installment loan will help you understand the true cost of the debt. If your loan is "discounted," this means that the lender will require interest up front instead of at the end of the period. Those who have a discounted loan have one extra step necessary to complete their effective interest calculation.
Items you will need
- Loan with compensating balance agreement
Typical Installment Loan with Compensating Balance
Look at your loan paperwork to determine the principal amount of the loan, the compensating balance required, and the stated interest rate. The compensating balance is typically expressed as a percentage of the principal of the loan, but some lenders may state a flat dollar value.
Calculate the nominal interest. This is done by taking the stated interest rate and multiplying it by the principal value. For instance, if you had a $100,000 loan with a 10 percent interest rate and a 5 percent compensating balance, your nominal interest would be $10,000 ($100,000 x 10 percent).
Calculate the compensating balance required. If you have a stated dollar amount for your compensating balance, this step is already completed for you. If you have a required compensating balance of a certain percentage, take that percent and multiply it by the stated principal. Using the same example from above, your required compensating balance would be $5,000 ($100,000 x 5 percent).
Calculate the available principal. This is done by subtracting the compensating balance required from the principal value stated in the loan. Using the same example, the available principal would be $95,000 ($100,000 - $5,000)
Divide the nominal interest by the available principal. This is your effective interest rate, and the true cost of the debt. In this example, the effective interest rate comes out to 10.53% ($10,000/$95,000).
Discount Installment Loan with Compensating Balance
Follow steps one through three from the Typical Installment Loan with Compensating Balance section.
Calculate the available principal. This is done by taking the full principal amount and subtracting the nominal interest and the compensating balance. Using the same example above, the available principal would work out to be $85,000. ($100,000 - $10,000 - $5,000)
Divide the nominal interest by the available principal. In this example, the effective interest rate works out to be 11.76 percent ($10,000/$85,000).
Calculate the effective interest rate of a loan before signing documents. This will give you an idea of the true cost of debt and help you evaluate all of your options.
Be sure you understand the terms of any loan agreement before signing the document. Once signed, you are legally responsible for the terms and conditions in the agreement.
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