Question

what is a compensating balance and how does it affect the interest rate on a line of credit?

Answer 1

In simple words, a compensating balance refers to the minimum balance that needs to be maintained in a bank account in order to compensate for the setup cost of the business loan extended by the bank. The company cannot use the compensating balance and the bank can extend the compensating balance as a loan to other borrowers.

The compensating balance allows a bank to recover the cost of the loan extended by the bank to the company fully or partially. The bank can extend the compensating balance as a loan to other companies to earn interest. Therefore, compensating balance allows a bank to charge a lower interest rate on a line of credit.