Everything You Need to Know About the Compensating Loan

TO BORROW MONEY EFFECTIVELY, loan brokers, finders, consultants, and potential borrowers must understand as many different methods as possible to increase the likelihood that a lender will make a desired loan.

FOR EVERY LOAN REQUEST, the lender weighs many variables, such as type of loan, amount, interest rates, repayment terms, borrower’s collateral, job status, earnings, credit score, credit history and other factors. To be an effective loan finder or borrower, you need to know how to use this information to secure the funds you, or your client, need.

THE COMPENSATING BALANCE LOAN

ONE METHOD THAT CAN HELP YOU, OR YOUR CLIENT, get 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. Such loans are most often made to businesses, although they are sometimes provided to individuals as well.

THE ACCOUNT THAT CONTAINS THE COMPENSATING BALANCE usually does not bear interest to the borrower, andthe lender is free to use the money as it wants. If the borrower fails to repay the loan as agreed, the bank can take the funds from the account.

A SIMPLE EXAMPLE

COMPENSATING BALANCES ARE TYPICALLY 10% of the amount of the loan.

A SIMPLE EXAMPLE OF THIS METHOD would be where a lender agrees to make a $100,000 loan as long as the borrower keeps a deposit balance of at least $10,000 in a savings, checking, or certificate of deposit (CD) account. The $10,000 is called the compensating balance.

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HOW IT WORKS

IT’S NOT UNCOMMON FOR LENDERS to subtract the interest and the compensating balance amount from the total principal of a compensating balance loan. For example, on a $25,000 loan at 8 percent interest for one year, the interest of $2,000 (8% of the loan) and the compensating balance amount of $2,500 (10%) may be subtracted from the $25,000 principal. Thus, the total amount the borrower gets is $20,500. This is only a general example. Individual lenders and specific loans may vary.

SOME LENDERS PREFER TO OFFER A LINE OF CREDIT rather than a regular loan when a compensating balance is used.

DESCRIBING THE LOAN

THE NAME “COMPENSATING BALANCE” HASN’T CAUGHT ON with all lenders, even though you’ll find it in financial texts like the Dictionary of Banking Terms and Dictionary of Business Terms. “Offsetting balance” is another name that is sometimes used.

GENERALLY, LENDERS WILL UNDERSTAND what you’re looking for when you describe the method—“an amount of money the borrower agrees to keep in an account as a condition for getting the loan.”

WHEN APPROACHING LENDERS about this kind of loan, be prepared to describe the method and explain the type of arrangement you want. Give an example like the one above if you need to.

SHOP AROUND

AS WITH ANY LOAN, IT’S WISEST TO SHOP AROUND at many different lenders. If one lender turns down a request for a compensating balance loan, the next one might make the loan you, or your client, need.

TO GET THIS TYPE OF LOAN, YOUR BEST BET is to go to commercial banks or credit unions. Commercial banks are often easily identified because their full names usually contain the letters “NA” (National Association) at the end. An example is “Century Bank NA” or “Century Bank N.A.”

ON THE FOLLOWING PAGES YOU’LL FIND MANY commercial banks and credit unions. Some of them may make the loan you want.

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TIPS FOR GETTING A COMPENSATING BALANCE LOAN

The larger the compensating balance in the borrower’s account, the easier it may be to get a compensating balance loan.

To set up a compensating balance loan, the borrower should have, or should open, a deposit account with the lender where the loan is requested.

Some lenders may offer a line of credit instead of a regular term loan. Borrowers should consider taking a line of credit, as it can be just as useful as a regular loan.

Be prepared to describe the method and give the lender an example of the type of loan you have in mind, since the lender might not use the term “compensating balance.”

It may be easier to get a compensating balance loan from a commercial bank or credit union than from other lenders, so these are good places to start.

Look to large lenders and lenders with locations in your area.

Shop around at different lenders. If one turns down your request, move on to the next.

Keep the lender happy. The borrower should keep the full amount of the compensating balance in the account at all times. It may be helpful to keep more than this amount in the account, if possible.

Since compensating balance loans are more commonly made to businesses, it may be easier to get a compensating balance loan if the borrower has an existing business.

CONCLUSION

COMPENSATING BALANCE LOANS can be a good way to fund a growing business. If the borrower can maintain the agreed-upon balance, a compensating balance loan can provide the cash the borrower needs to prosper.