Now what is a compensating balance? Well, it’s nothing more than the bank saying “hey, we loaned you one hundred thousand dollars… the least you can do is have thirty thousand dollars in an account with us. Oh, and let’s not touch that money, ok?”
Oh really? That’s the least we can do? Let me tell you something, Mister (or Ms.) bank person – if we had thirty grand in an account just sitting there doing nothing, we probably wouldn’t need the loan, would we?
Sheesh… but yes, that’s often how it works. The bank will typically require you to carry a big bank balance (usually 30% or so)… one that they’d rather you didn’t let go down, either. They call this a “compensating balance”, basically meaning “we loaned you money, you can compensate by having a good chunk of that money here with us…”
It’s almost bizarre, isn’t it? They loan you, say, $100,000, but require you to keep $30,000 in an account with them. So they are really only loaning you $70,000. The rest is actually YOUR money. Plus, doing that plays games with your interest rate. Say the loan interest is 7.5% – but if you factor in the point that you are required to keep 30% of the loan in the bank, the real yield for them is 9.33% (warning – math ahead:))
- Let’s just do a simple example with one year, and a nice round number, like $100,000 at 7.5% interest. In that scenario, you are going to pay $7,500 in interest, and the bank will be more than happy to let you assume this: $100,000 x 7.5% = $7,500. Simple, right?
- However, because of the compensating balance, you’re really only borrowing $70,000. So $70,000 x ? = $7,500. To get this, we’ll divide (you remember math class, right?)
- So $70,000 / $7,500 = 9.33% – this is the rate you are actually paying.
Obviously, the bank loves this little game. You pay more, plus, it ties up your cash.
Now let’s shift to an equipment financing company. We really don’t care what your bank balances are, to be honest. Oh sure, your assets will come into play when we approve you, but there’s no restrictions on how much you keep in the bank afterwards. So the rate you pay us is the real rate – no games, and you are free to do whatever you want with your cash. Exactly like it should be.
Oh, and very little math, too!