Legal Definitions - compensating balance

A compensating balance refers to a specific amount of money that a borrower is required to keep on deposit in an account at the lending bank as a condition for receiving a loan or a line of credit. This requirement means that a portion of the borrowed funds, or the borrower's own capital, remains tied up and unavailable for their immediate use, effectively increasing the true cost of the financing.

• Example 1: Small Business Expansion Loan

  A local bakery, "Sweet Delights," applies for a $150,000 loan from its bank to purchase new ovens and expand its seating area. The bank approves the loan but stipulates in the agreement that Sweet Delights must maintain a minimum balance of $15,000 in its business checking account with that bank for the duration of the loan. Even though the bakery is paying interest on the full $150,000, only $135,000 is truly available for its expansion project.

  This illustrates a compensating balance because the bank requires Sweet Delights to keep a portion of the loan amount (or its equivalent) on deposit, making that money inaccessible to the business while still charging interest on the entire principal.

• Example 2: Corporate Line of Credit

  Tech Innovations Inc., a growing software company, secures a $5 million revolving line of credit from its primary bank to manage seasonal cash flow fluctuations. As part of the agreement, the bank requires Tech Innovations to maintain a compensating balance equal to 10% of the *unused* portion of the line of credit, or a minimum of $250,000, whichever is greater, in a non-interest-bearing account. This means that even if Tech Innovations hasn't drawn any funds from the line of credit, it must still keep at least $250,000 in a deposit account at the bank.

  Here, the compensating balance ensures the bank has a stable deposit base from its borrower, even when the line of credit isn't fully utilized. It ties up the company's capital, affecting its liquidity and the effective cost of having the credit facility available.