However, the effective interest rate on a loan with a compensating balance is actually higher than a balance-free loan. In addition to loans, a compensating balance approach may be used to secure a line of credit. The compensating balance loan, on the other hand, will have lower rates but a percentage required to be held as a compensating balance. This question hasn't been answered yet Ask an expert Such loans are most often made to businesses, although they may be provided for real estate as well. e. none of the above. 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. Bank Two requires Capital to maintain compensating balances equal to 10% of the amount of the line. A compensating balance is especially common with corporate loans. The compensating balance offsets the bank's default risk and can be used to make new loans. Compensating balance is the amount of fund that must be withheld at the bank when a loan is originated. please show work = (interest / (principal - interest)) X (days in the year / days loan is outstanding) effective rate with compensating balances = interest / (1-compensating balance as decimal) 61. (Do not round intermediate calculations. The amount in the account is used to offset an unpaid loan. But who will provide a compensating balance loan? In business finances I often hear about fee added loans versus compensating balance loans with no fees. league baseball, and cycling. In the event that the compensating balance drops below the minimum required, the interest rate applied to the loan will rise accordingly. A compensating balance on a bank loan effectively _____ the cost of the loan. 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~. Bankers often offer this as a means of obtaining a more favorable interest rate on loans extended to existing bank customers. compensating balance. Compensating balance . 12) The Stant Shoe Company established a line of credit with a local bank. C) 11.6% . 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 fund is used to offset the cost of the loan to the bank. 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 devotional anthologies, and several newspapers. The terms follow:… Explanation. Introducing Textbook Solutions. No interest is earned on the compensating balance, which is stated as a percentage of the loan. It means the effective loan amount is $45,000 only. Compensating balances are minimum balances that may be maintained in an account and still meet the requirements for a loan. The effective cost of borrowing is (rounded to the nearest hundredth) In this manner, the cost for providing loans is reduced, and both the bank and the borrower benefit from the transaction. 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. @ Babalaas - This creates a tough choice. a. In addition, the bank requires you to maintain a 15 percent compensating balance in the bank. $7,000 / $80,000 = 8.75%. The average shall be calculated quarterly. 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. variety of print and online publications, including wiseGEEK, and his work has also appeared in poetry collections, Sometimes referred to as an offsetting balance, the purpose of the compensating balance is to offset the expenses associated with extending … 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. By the time the credit line is accessed and drawn on, the balance in the compensating account will be $15,000.00 USD. Compensating balance is the least or minimum balance that an organization or an individual needs to keep with the lender. Question 9 2.5 out of 2.5 points A compensating balance on a bank loan effectively _____ the cost of the loan. In addition to loans, a compensating balance approach may be used to secure a line of credit. 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. 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. As proceeds decline, the effective interest rate rises. trivia, research, and writing by becoming a full-time freelance writer. 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? However, the borrower must maintain a balance of 25 percent of the amount of the loan, and the balance does not earn any interest. b. lowers. This is because in a fee added loan, the fees are considered a part of the interest. 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. Confidence Bank has made a loan to Risky Corporation. 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. D) 12.3% . Week 11 Chapters 15, 16, 17, and 18 Quiz .docx, Week 11, Quiz 5 - FIN100 - Principles of Finance.docx. To determine the rate on a fee added loan you just add the fees as a percentage of the principle to the interest. After many years in the teleconferencing industry, Michael decided to embrace his passion for 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. Here’s an example. Key Takeaways Agreeing to a compensating balance allows a company to borrow money at a favorable rate of interest. @ Glasshouse and Babalaas - You should also take into account what the loan is for. 7.5% b. 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 balances also decrease the proceeds of the loan. 11.1%; To calculate the effective interest rate on a loan with a compensating balance requirement. The compensating balance is usually 10%. For a limited time, find answers and explanations to over 1.2 million textbook exercises for FREE! The most common structure for a compensating balance is very simple. 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. The compensating balance increases the effective interest rate the loan. The checking account … A. A compensating balance is an amount that the bank makes you hold in a savings account or separate account during a loan term. The effective annual interest rate of this loan is Submitted: 15 years ago. This means an effective interest rate of15% ($1,200,000 interest … A compensating balance loan has a 20% compensating balance and an 8% rate. The business borrower must report the … It's a debt covenant. 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 … B. 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. 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. Course Hero is not sponsored or endorsed by any college or university. If you used either of Glasshouse’s loan scenarios you would effectively be earning between 4.39% and 4.69% on the discount. A minimum balance that must be maintained in an account. This serves as a kind of collateral and can result in a lower interest rate. The discount would be 2% if paid in ten days or none if paid in 60 (2/10 net 60). The primary objective of such a balance is to reduce the lending cost of a borrower. Combining positively correlated assets having the … A compensating balance increases the effective interest rate to the bank as the net amount loaned is reduced and the interest paid remains unchanged. Solution for Justin Company is in the process of negotiating a line of credit with two local banks. a. raises. Choice "d" is correct. c. has no effect on. present value of its initial investment is called the. A) 9.5% . 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. When a bank issues you a compensating balance loan, it requires that you maintain a bank account there with a minimum balance. Example: You borrow $ 30,000 at 12%. The Bank requires that you maintain a 10% compensating balance. Compensating Balance. Tristan Inc. has a bank loan. Which of the following statements is most correct? In the event that the compensating balance drops below the minimum required, the interest rate applied to the loan will rise accordingly. Get step-by-step explanations, verified by experts. 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. The Altmane Corporation was recently quoted terms on a commercial bank loan of 7% discounted interest with a 20% compensating balance. Tom Sander is a loan officer with Miami National Bank. Compensating balance - definition of compensating balance by The Free Dictionary 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}. The bank typically charges 8% APR on loans with a compensating balance requirement of 10%. Compensating Balances. B) 10.6% . 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. 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. This would make a loan for $100,000 a better deal with the compensating balance. Question: 15) If A Bank Offers A 10% Discounted Loan With A 5% Compensating Balance, What Is The Effective Rate? 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