What is a Compensating Balance?
A compensating balance is money a customer keeps in a bank account that doesn’t earn interest. The customer has to keep this money in the account to “compensate” or pay the bank back for giving the customer loans or other banking services. It’s like the bank saying, “I’ll lend you money or help you out, but you have to keep some cash parked with me in return.”
Demand Deposits
The compensating balance has to be in a “demand deposit” account. That’s just a fancy way of saying it’s in a regular checking account where customers can take the money out whenever they want. The money is there “on demand.” The customer can’t put the compensating balance in a savings account or a certificate of deposit that would lock the money up for a while.
No Interest Allowed
Here’s the catch – the compensating balance can’t earn ANY interest. Zip, zero, nada. The bank gets to hold onto the customer’s money but doesn’t have to pay the customer anything for the privilege. It’s all part of the deal. The bank is giving the customer a loan or other perks, so the customer agrees to let the bank hold some of their money interest-free in exchange.
How Compensating Balances Work
Let’s say you’re a businessperson and you need a $500,000 loan from your bank to expand your widget factory. You meet with your banker, do a secret handshake, and hammer out a deal. The bank says, “We’ll give you the half a million bucks, but you have to keep $50,000 in a noninterest checking account with us. That’s your compensating balance.”
The Compensating Balance Calculation
The amount of the compensating balance is usually a percentage of the loan amount. In this example, it’s 10% of the $500,000 loan. The bank figures out how much money it wants to have on hand based on the size of the loan it’s giving out. Bigger loan, bigger compensating balance.
Locked Up Money
The $50,000 has to stay in your checking account as long as you have the loan from the bank. It’s kind of held hostage. If you withdraw some or all of the compensating balance, the bank can get ticked off and consider you in default on your loan agreement. That’s not a good scene. They could demand you repay the whole loan immediately or refuse to lend you more money in the future.
The Bank’s Advantage
The bank loves compensating balances. It’s like free money for them. They get to hold onto your $50,000, lend it out to other customers, and make money on the interest they charge those different customers. Meanwhile, they don’t have to pay you diddly-squat in interest for your $50,000. It’s a pretty sweet deal if you’re the bank!
Pros and Cons of Compensating Balances
Advantages for the Customer
You might think, “This compensating balance business sounds like a rip-off! Why would I agree to that?” Well, there can be some upsides for the customer, too:
You Get the Loan
The most significant benefit is getting the loan you need for your business. If the bank requires a compensating balance and you agree, they’ll give you the money. If you say, “No way, Jose!” to the compensating balance, the bank might say, “No way, Jose!” to your loan request. Sometimes, you gotta do what you gotta do to get the cash your business needs.
Easier Loan Approval
Banks like compensating balances because they lower the bank’s risk. With some of your money on deposit, the bank figures you’re more likely to repay the loan. So they may be more willing to approve a loan with a compensating balance than without one, even if your credit rating isn’t quite as strong as they’d normally like.
Lower Interest Rate
Sometimes, a bank will charge a slightly lower interest rate on a loan with a compensating balance. They figure they’re making money by lending out your balance, so they can afford to give you a little break on the loan rate. It’s not always the case, but it sometimes happens.
Stronger Relationship
Having a chunk of money parked at the bank can strengthen your overall relationship with the bank. They may see you as a more valuable customer and be more willing to work with you in the future, give you good deals, or help you out if you have a cash crunch. Again, no guarantees, but it can work that way.
Disadvantages for the Customer
Now, the downsides of compensating balances for customers:
Opportunity Costs
The biggest downside is the opportunity cost of the money in the compensating balance. While your money is sitting in a noninterest account, it’s not out there working for you. You can’t invest it in your business, you’re not earning interest on it, you can’t use it for anything else. There’s a real cost to having money tied up doing nothing.
Unproductive Money
Cash is king and you want to keep your cash productive at all times. You want your money making you more money. But the money in a compensating balance is just dead weight. It’s unproductive cash. And that’s not a good thing in business.
Loss of Liquidity
Depending on how much of your money is in the compensating balance, you may be a little short on liquidity. Liquidity is how much cash you have available for immediate spending needs. With money locked up in the compensating balance, you may have to scramble to find cash to pay bills or make purchases. Loss of liquidity is never fun.
Negotiating Compensating Balances
You don’t necessarily have just to accept a compensating balance if a bank asks for it. Everything is negotiable, even this. You can try negotiating a lower compensating balance or have it phased out over time as you prove yourself to be a solid customer. Here are some negotiating tips:
Shop Around
Talk to multiple banks and see what they require to compensate balances. If you find a bank that’s willing to lend without a compensating balance or with a lower one, you can use that as leverage with the first bank. Say, “Hey, First National Bank down the street doesn’t require a compensating balance. Can you match that deal?”
Remind the Bank of the Big Picture
Sure, the bank would love to get some free money from you as a compensating balance. But remind them of how much money you’ll be paying them in interest over the life of the loan. Say, “I will pay you $50,000 in interest with this loan. How about we knock the compensating balance down to $25,000 and call it a day?”
Offer Alternatives
See if the bank will take something besides a checking account compensating balance. Maybe you can do a compensating balance with a savings account that earns a little interest. Or perhaps you can offer some other collateral like business equipment or real estate instead of a cash balance.
Demonstrate Your Solid Business
If you can show the bank that you have a rock-solid business with strong cash flow and excellent prospects, they may not need a big compensating balance. Prove to them that you’re a blue chip customer and they’d be lucky to have your business with or without a compensating balance.
Compensating Balance Wrap-up
So there you have it, the scoop on compensating balances. They’re a way for banks to get something extra from customers when making loans. They can be a pain for customers, but sometimes they’re a necessary evil to get the financing you need.
The key points to remember:
- Compensating balances are money you have to keep in a noninterest bank account when you get a loan
- The compensating balance amount is usually a percentage of the loan amount
- Banks like compensating balances because they reduce their risk and give them some extra cash to play with
- Customers can sometimes negotiate compensating balances, but they don’t have all the leverage
Hopefully, this will clear up any confusion about compensating balances. It’s good to understand how they work so you know what you’re getting into if a bank asks for one. And if you have a compensating balance with a bank now, maybe it will inspire you to negotiate a better deal. It never hurts to ask!
