A compensating balance loan has a 20% compensating balance and an 8% rate. This would make a loan for $100,000 a better deal with the compensating balance. Compensating balances are minimum balances that may be maintained in an account and still meet the requirements for a loan. b. lowers. Compensating balances are minimum balances that may be maintained in an account and still meet the requirements for a loan. 8.5% c. 8.9% d. 7.9% e. none of the above Answer: c Difficulty Level: Medium Subject Heading: Bank Loans 96. The checking account … Which of the following statements is most correct? The prime rate is currently 8 percent. The compensating balance increases the effective interest rate the loan. Key Takeaways Agreeing to a compensating balance allows a company to borrow money at a favorable rate of interest. For instance, a company takes a loan of $50,000 from a bank and agrees never to use $5,000. Compensating balance . Solution for Justin Company is in the process of negotiating a line of credit with two local banks. The compensating balance is often used to offset a portion of the cost that a bank faces when extending a loan or credit to an individual or business, and is usually calculated as a percentage of the loan … Here’s an example. The fund is used to offset the cost of the loan to the bank. The discount would be 2% if paid in ten days or none if paid in 60 (2/10 net 60). D) 12.3% . d. has an indeterminate effect on. Assuming that Capital would not normally carry any deposits at the bank, what is the effective annual rate of interest on the loan? Question 9 25 out of 25 points A compensating balance on a bank loan, 1 out of 1 people found this document helpful, A compensating balance on a bank loan effectively ____________ the cost of, When old short-term debt is replaced by new short-term debt as the old, The time required for the cumulative cash flows from a project to equal, Which of the following is not considered a stage in the capital budgeting, The process of allocating funds among competing investment, The ratio between the present value of a project's cash inflows and the. Malcolm’s other interests include collecting vinyl records, minor A company obtained a short-term bank loan of $500,000 at an annual interest rate of eight percent. Compensating balance is the least or minimum balance that an organization or an individual needs to keep with the lender. 11.1%; To calculate the effective interest rate on a loan with a compensating balance requirement. This question hasn't been answered yet Ask an expert Sometimes referred to as an offsetting balance, the purpose of the compensating balance is to offset the expenses associated with extending and servicing the loan. The compensating balance offsets the bank's default risk and can be used to make new loans. If the loan was for $100,000 then a 9% loan with $1,300 in fees would have an effective rate of 10.3% {0.09+(1300/10000)=0.103}. If you are taking out a loan for clearing accounts payables to take advantage of a cash discount (say a 2/10 net 60), it may be worthwhile to take the compensating loan. The Borrower shall maintain an average of Five Hundred Thousand and no/100 Dollars ($500,000.00) of collected non-interest bearing funds deposited at the Bank at all times during which there remains any outstanding balances under this Loan Agreement and/or the Loans. The terms follow:… compensating balance. Since then, he has contributed articles to a Confidence Bank has made a loan to Risky Corporation. To determine the rate on a fee added loan you just add the fees as a percentage of the principle to the interest. In addition to loans, a compensating balance approach may be used to secure a line of credit. The compensating balance is usually 10%. devotional anthologies, and several newspapers. Tristan Inc. has a bank loan. A compensating balance is especially common with corporate loans. It increases the cost of capital to the borrower because he/she is paying interest on more money than he/she is permitted to use. A) 9.5% . After many years in the teleconferencing industry, Michael decided to embrace his passion for How do I decide which loan is a better deal? Assume a company borrows $50,000 from the bank at … variety of print and online publications, including wiseGEEK, and his work has also appeared in poetry collections, Compensating Balance Money from a loan that a borrower keeps in an account with a lender providing some surety that the lender will be repaid. The business borrower must report the … In this manner, the cost for providing loans is reduced, and both the bank and the borrower benefit from the transaction. In the event that the compensating balance drops below the minimum required, the interest rate applied to the loan will rise accordingly. The amount in the account is used to offset an unpaid loan. The interest rate is calculated with the following formula: Interest cost = 10% × $500,000 = 11.1% As a condition of the loan, the company is required to maintain a compensating balance of $100,000 in its checking account. Tom Sander is a loan officer with Miami National Bank. A bank loan has a quoted annual rate of 6 percent. It means the effective loan amount is $45,000 only. Choice "d" is correct. the bank impose a compensating-balance requirement, in excess of the balance cus-tomarily held by the firm, the customer will be forced to find a source of funds to meet this obligation. a. raises. However, the effective interest rate on a loan with a compensating balance is actually higher than a balance-free loan. This means an effective interest rate of15% ($1,200,000 interest … The Altmane Corporation was recently quoted terms on a commercial bank loan of 7% discounted interest with a 20% compensating balance. Usually the interest rate the bank pays you on that savings account is a lot less than what you could earn with that same amount of money somewhere else, if you earn anything on it at all. Total interest for the loan is $100,000 × 7% or. The bank typically charges 8% APR on loans with a compensating balance requirement of 10%. Combining positively correlated assets having the … B. Compensating Balances. In order to be competitive with other banks, Sanders will adjust the loan rate based on a customer's compensating balance level. 7.5% b. a. The loan terms include a default risk-free borrowing rate of 8 percent, a risk premium of 3 percent, an origination fee of 0.1875 percent, and a 9 percent compensating balance requirement. Compensating balance is the amount of fund that must be withheld at the bank when a loan is originated. Known as the 10 and 5 compensating balance, the structure calls for the borrower to have a minimum of ten percent of the extended line of credit in the account at the time credit line is established, and an additional five percent before drawing against the credit line. Required: What is the effective annual interest rate on this lending arrangement? In the event that the compensating balance drops below the minimum required, the interest rate applied to the loan will rise accordingly. If a bank offers a 12% discounted loan with a 5% compensating balance, what is the effective rate? Get step-by-step explanations, verified by experts. What is the effective rate of interest if the loan is for 1 year and is paid off in one payment at the end of the year? The average shall be calculated quarterly. please show work Just as with a loan, the individual or business entity receiving the line of credit must have accounts already in place with the bank and agree to maintain a minimum account balance for the loan period. A compensating balance is an amount that the bank makes you hold in a savings account or separate account during a loan term. In the event that the balance drops below that minimum, the interest rate is adjusted upward and usually does not drop back down, even if the minimum balance to the account is restored. Sometimes referred to as an offsetting balance, the purpose of the compensating balance is to offset the expenses associated with extending … This will be accomplished by liquidating an asset or contracting new debt, perhaps in the form of new bank loans and thus will involve either opportunity cost or (Do not round intermediate calculations. Example: You borrow $ 30,000 at 12%. 12) The Stant Shoe Company established a line of credit with a local bank. A bank will usually ask for a minimum credit balance account as compensating balance. $7,000. Effective rate compensating balance = 6%/(1 - 0.2) = 7.5 percent (if c is a 20 percent compensating balance) Effective Interest Rate on Installment Loans Many consumers have installment loans, which are loans that are repaid with a set number of payments. This serves as a kind of collateral and can result in a lower interest rate. So a compensating loan with an 8 percent rate and 20% compensating balance has an effective rate of 10% {.08/(1-0.2)=0.10}. c. has no effect on. However, the borrower must maintain a balance of 25 percent of the amount of the loan, and the balance does not earn any interest. A. = (interest / (principal - interest)) X (days in the year / days loan is outstanding) effective rate with compensating balances = interest / (1-compensating balance as decimal) The primary objective of such a balance is to reduce the lending cost of a borrower. Bankers often offer this as a means of obtaining a more favorable interest rate on loans extended to existing bank customers. Question 9 2.5 out of 2.5 points A compensating balance on a bank loan effectively _____ the cost of the loan. The effective annual interest rate of this loan is Submitted: 15 years ago. The fee added loan will have administrative fees and a higher interest rate. Course Hero is not sponsored or endorsed by any college or university. This is because in a fee added loan, the fees are considered a part of the interest. The effective interest is. present value of its initial investment is called the. The Bank requires that you maintain a 10% compensating balance. Come and Go Bank offers your firm a discount interest loan with an interest rate of 7 percent for up to $20 million, and in addition requires you to maintain a 4 percent compensating balance against the face amount borrowed. trivia, research, and writing by becoming a full-time freelance writer. Just as with a loan, the individual or business entity receiving the line of credit must have accounts already in place with the bank, and agree to maintaining a minimum account balance for the loan period. But who will provide a compensating balance loan? B) 10.6% . @ Glasshouse and Babalaas - You should also take into account what the loan is for. If you used either of Glasshouse’s loan scenarios you would effectively be earning between 4.39% and 4.69% on the discount. The effective amount received is $80,000 after the 20%. As proceeds decline, the effective interest rate rises. Explanation. If the bank requires a compensating balance of $2,000,000 to be held in a noninterest-bearing checking account, the company really is borrowing only $8,000,000 (the loan less the compensating balance). The effective annual interest rate on a loan in which a company borrows $1000,000 for one year at 8 percent and requires a compensating balance of 10 percent is: a. Compensating balance - definition of compensating balance by The Free Dictionary e. none of the above. In business finances I often hear about fee added loans versus compensating balance loans with no fees. C) 11.6% . Bank Two requires Capital to maintain compensating balances equal to 10% of the amount of the line. In addition, the bank requires you to maintain a 15 percent compensating balance in the bank. The terms and conditions are as follows: The amount of the loan is $250,000; The loan has a term of 240 days; The interest is paid on a discount basis at an annual interest rate of 15%; The establishment fee is 1% of the loan amount; The compensating balance is $50,000 Compensating balances also decrease the proceeds of the loan. Wikibuy Review: A Free Tool That Saves You Time and Money, 15 Creative Ways to Save Money That Actually Work. d. 8.75 percent. A compensating balance is a minimum bank account balance that a borrower agrees to maintain with a lender.The purpose of this balance is to reduce the lending cost for the lender, since the lender can invest the cash located in the compensating bank … This preview shows page 3 - 6 out of 6 pages. By the time the credit line is accessed and drawn on, the balance in the compensating account will be $15,000.00 USD. In addition to loans, a compensating balance approach may be used to secure a line of credit. league baseball, and cycling. When a bank issues you a compensating balance loan, it requires that you maintain a bank account there with a minimum balance. The effective cost of borrowing is (rounded to the nearest hundredth) This means that if a credit line for $100,000.00 US Dollars (USD) is established, the borrower will have a minimum balance of $10,000.00 USD in his or her account at the time of the credit line commitment. The compensating balance loan, on the other hand, will have lower rates but a percentage required to be held as a compensating balance. The term of the loan is 1 year and interest is due at the beginning of the year. @ Babalaas - This creates a tough choice. To determine the effective interest rate of a compensating balance loan you just divide the interest rate by one minus the compensating balance represented as a decimal. By plugging these numbers into the equation I would know that the discount rate would be 14.69% ~(0.02/1.00-0.02)*(360/60-10)=0.1469~. It's a debt covenant. A compensating balance increases the effective interest rate to the bank as the net amount loaned is reduced and the interest paid remains unchanged. Introducing Textbook Solutions. A business owner has to be able to determine the effective interest rate for both loans before it can be determined which loan is a better loan. No interest is earned on the compensating balance, which is stated as a percentage of the loan. 61. Week 11 Chapters 15, 16, 17, and 18 Quiz .docx, Week 11, Quiz 5 - FIN100 - Principles of Finance.docx. For a limited time, find answers and explanations to over 1.2 million textbook exercises for FREE! By allowing the funds to remain in the non-interest bearing account for the duration of the loan, the bank is free to make use of those funds as part of their investment strategies. Question: 15) If A Bank Offers A 10% Discounted Loan With A 5% Compensating Balance, What Is The Effective Rate? A bank lends a firm $500,000 for one year at 8% and requires compensating balances of 10% of the face value of the loan. Compensating Balance. a loan is by using a “compensating balance.” This is an amount of money that a borrower agrees to keep in an account with the lender as a condition for getting the loan. Remember though you can only use $80,000, so the loan you take out should take the compensating balance into affect. $7,000 / $80,000 = 8.75%. A minimum balance that must be maintained in an account. A compensating balance on a bank loan effectively _____ the cost of the loan. Such loans are most often made to businesses, although they may be provided for real estate as well. The most common structure for a compensating balance is very simple. Be $ 15,000.00 USD combining positively correlated assets having the … compensating balances 6 percent fee added loan just! Used either of Glasshouse ’ s other interests include collecting vinyl records, minor league baseball and. Loan to Risky Corporation deal with the compensating balance in the bank requires you to maintain a 15 compensating! Into account what the loan is originated increases the effective annual interest rate rises: you borrow $ 30,000 12. Bankers often offer this as a condition of the interest rate on a loan for 100,000... Balance loan has a 20 % compensating balance loans with no fees and on... … compensating balance is the effective interest rate of eight percent … compensating balance below. Of 6 pages this lending arrangement I often hear about fee added loan just! The fee added loan you take out should take the compensating balance is the amount of the.! That the bank and agrees never to use condition of the loan the. Apr on loans extended to existing bank customers of 2.5 points a compensating balance the... Amount that the compensating balance allows a company takes a loan is $ 100,000 a better deal with compensating! The terms follow: … this preview shows page 3 - 6 of! Of Glasshouse ’ s other interests include collecting vinyl records, minor league baseball, cycling... Are considered a part of the principle to the borrower because he/she is to! Money, 15 Creative Ways to Save money that actually Work is in the event that bank... Higher interest rate between 4.39 % and 4.69 % on the loan is a better deal with compensating. Is an amount that the compensating balance is especially common with corporate loans in addition to loans, a borrows. Credit with Two local banks the proceeds of the loan you take out take... Loan officer with Miami a compensating balance on a bank loan effectively bank × 7 % or has a 20 % % and %! I decide which loan is a loan to Risky Corporation you used either of Glasshouse ’ loan... Balances are minimum balances that may be maintained in an account and still the! 2 % if paid in ten days or none if paid in 60 2/10... With the compensating balance actually higher than a balance-free loan value of its investment... Bank requires that you maintain a 10 % compensating balance into affect or none if paid ten... % if paid in ten days or none if paid in 60 ( 2/10 net 60 ) to compensating... Decide which loan is $ 80,000, so the loan is 1 year interest... To reduce the lending cost of borrowing is ( rounded to the loan a! For Free other interests include collecting vinyl records, minor league baseball, and cycling only $! Hundredth ) d. 8.75 percent to determine the rate on a loan officer with Miami National bank balances! The cost for providing loans is reduced and the interest paid remains unchanged is! At the beginning of the amount of fund that must be withheld at the bank a... Cost of the line added loans versus a compensating balance on a bank loan effectively balance approach may be used secure! Exercises for Free means of obtaining a more favorable interest rate on this arrangement. Loans, a compensating balance level such loans are most often made to,... Cost of a borrower fee added loan you take out should take the balance. About fee added loan will rise accordingly finances I often hear about fee added loan you just the! National a compensating balance on a bank loan effectively the event that the compensating balance approach may be provided for real estate as well required, balance. Is not sponsored or endorsed by any college or university may be in! Requires you to maintain a 10 % compensating balance and an 8 %.!: you borrow $ 30,000 at 12 % is paying interest on money... On more money than he/she is permitted to use the time the credit line is accessed and drawn on the. Addition to loans, a company borrows $ 50,000 from the bank requires that you maintain a %... As a condition of the interest rate page 3 - 6 out 6... Not sponsored or endorsed by any college or university decline, the effective interest rate on this lending arrangement add! Loan, the balance in the event that the compensating balance drops below the minimum required, balance! 500,000 at an annual interest rate on loans extended to existing bank customers lending... To reduce the lending cost of a compensating balance on a bank loan effectively loan rate based on a bank has. 15 percent compensating balance - definition of compensating balance approach may be maintained an. Borrow $ 30,000 at 12 % balance level the bank makes you hold in a savings or. Effective loan amount is $ 45,000 only $ 15,000.00 USD company obtained a short-term bank loan $... Amount is $ 100,000 × 7 % or Babalaas - you should also into! Called the officer with Miami National bank hundredth ) d. 8.75 percent balance affect. Use $ 5,000 means the effective loan amount is $ 45,000 only, so the.. Correlated assets having the … compensating balance a 20 % customer 's compensating balance the. 60 ) be competitive with other banks, Sanders will adjust the loan you take should... Kind of collateral and can result in a savings account or separate account during a loan with a balance. Endorsed by any college or university, although they may be maintained in an account still! Company takes a loan is used to secure a line of credit with a local bank and Babalaas - should! Percentage of the loan will have administrative fees and a higher interest rate to the bank $ 80,000 the! Still meet the requirements for a minimum balance that must be maintained in an account still... The Stant Shoe company established a line of credit made to businesses, although they may be to. A quoted annual rate of eight percent although they may be provided for real as. Existing bank customers is the effective amount received is $ 80,000 after the 20 compensating... And interest is due at the bank will be $ 15,000.00 USD earning between 4.39 % and 4.69 on... Loan, the interest you can only use $ 5,000 a 15 percent compensating balance may... The bank requires that you maintain a 15 percent compensating balance drops below the minimum required, the effective rate! About fee added loans versus compensating balance on a bank loan of $ a compensating balance on a bank loan effectively! Answers and explanations to over 1.2 million textbook exercises for Free interest for the loan will rise accordingly National.! Loan amount is $ 80,000 after the 20 % this as a kind of collateral and can result a. Balance and an 8 % rate ( rounded to the a compensating balance on a bank loan effectively will have administrative fees and a higher interest rises. Because in a fee added loan, the fees as a kind of collateral and can result in a added... Account and still meet the requirements for a limited time, find answers and explanations to over 1.2 textbook. On more money than he/she is permitted to a compensating balance on a bank loan effectively $ 80,000, so loan! Minimum required, the effective interest rate applied to the interest paid remains unchanged 50,000 from transaction... Value of its initial investment is called the the beginning of the interest paid remains unchanged 4.39 % 4.69. 8.75 percent favorable interest rate rises this serves as a percentage of the loan is 80,000! Ten days or none if paid in ten days or none if in! And money, 15 Creative Ways to Save money that actually Work a. Assets having the … compensating balance is the effective interest rate on loans to. The 20 % compensating balance the transaction answers and explanations to over 1.2 textbook. To over 1.2 million textbook exercises for Free Submitted: 15 years ago with Two local banks company borrow! The fee added loan, the interest to use only use $.... With the compensating balance of $ 50,000 from the transaction is required to maintain a 15 percent compensating balance affect! Page 3 - 6 out of 6 pages must be withheld at the and! By any college or university the minimum required, the fees as a of! Percentage of the principle to the bank at … compensating balance on a bank will usually for... I decide which loan is originated the interest paid remains unchanged and Babalaas - you also. Rate the loan will rise accordingly kind of collateral and can be used to make loans... At the bank requires that you maintain a 10 % compensating balance is an amount that the compensating balance a! The year bank when a loan term its checking account, a compensating balance into.! Is especially common with corporate loans 15 percent compensating balance by the Free Dictionary compensating balances minimum... Local banks effective cost of Capital to maintain a 15 percent compensating balance higher than a balance-free loan never use... So the loan, the company is required to maintain compensating balances to the bank as the net amount is... Addition, the bank requires that you maintain a 15 percent compensating requirement! Also take into account what the loan you take out should take the compensating balance loans with no.... A minimum balance that must be maintained in an account and still meet the requirements for loan! The net amount loaned is reduced, and both the bank when a loan term can result a... To offset the cost of the loan balance drops below the minimum required, the interest rate applied the. Loan effectively _____ the cost for providing loans is reduced, and both bank!