The effective interest is. Assuming that Capital would not normally carry any deposits at the bank, what is the effective annual rate of interest on the loan? 7.5% b. Compensating balance . A compensating balance increases the effective interest rate to the bank as the net amount loaned is reduced and the interest paid remains unchanged. devotional anthologies, and several newspapers. Total interest for the loan is $100,000 × 7% or. Required: What is the effective annual interest rate on this lending arrangement? Get step-by-step explanations, verified by experts. The average shall be calculated quarterly. (Do not round intermediate calculations. Compensating Balances. The interest rate is calculated with the following formula: Interest cost = 10% × $500,000 = 11.1% compensating balance. In addition to loans, a compensating balance approach may be used to secure a line of credit. 8.5% c. 8.9% d. 7.9% e. none of the above Answer: c Difficulty Level: Medium Subject Heading: Bank Loans 96. 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. Tristan Inc. has a bank loan. In this manner, the cost for providing loans is reduced, and both the bank and the borrower benefit from the transaction. = (interest / (principal - interest)) X (days in the year / days loan is outstanding) effective rate with compensating balances = interest / (1-compensating balance as decimal) 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. Such loans are most often made to businesses, although they may be provided for real estate as well. 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. trivia, research, and writing by becoming a full-time freelance writer. 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. The most common structure for a compensating balance is very simple. The effective cost of borrowing is (rounded to the nearest hundredth) Solution for Justin Company is in the process of negotiating a line of credit with two local banks. The fund is used to offset the cost of the loan to the bank. A. A compensating balance is an amount that the bank makes you hold in a savings account or separate account during a loan term. 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. 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. Malcolm’s other interests include collecting vinyl records, minor Compensating balances are minimum balances that may be maintained in an account and still meet the requirements for a loan. 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. a. Here’s an example. 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. $7,000. As proceeds decline, the effective interest rate rises. 61. 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. How do I decide which loan is a better deal? A) 9.5% . By allowing the funds to remain in the non-interest bearing account for the duration of the loan, the bank is free to make use of those funds as part of their investment strategies. 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. A company obtained a short-term bank loan of $500,000 at an annual interest rate of eight percent. If you used either of Glasshouse’s loan scenarios you would effectively be earning between 4.39% and 4.69% on the discount. The fee added loan will have administrative fees and a higher interest rate. b. lowers. The effective amount received is $80,000 after the 20%. Question 9 2.5 out of 2.5 points A compensating balance on a bank loan effectively _____ the cost of the loan. The terms follow:… The amount in the account is used to offset an unpaid loan. But who will provide a compensating balance loan? Since then, he has contributed articles to a In the event that the compensating balance drops below the minimum required, the interest rate applied to the loan will rise accordingly. Compensating balances also decrease the proceeds of the loan. As a condition of the loan, the company is required to maintain a compensating balance of $100,000 in its checking account. To determine the rate on a fee added loan you just add the fees as a percentage of the principle to the interest. The Altmane Corporation was recently quoted terms on a commercial bank loan of 7% discounted interest with a 20% compensating balance. Remember though you can only use $80,000, so the loan you take out should take the compensating balance into affect. This serves as a kind of collateral and can result in a lower interest rate. So a compensating loan with an 8 percent rate and 20% compensating balance has an effective rate of 10% {.08/(1-0.2)=0.10}. Sometimes referred to as an offsetting balance, the purpose of the compensating balance is to offset the expenses associated with extending … league baseball, and cycling. Compensating balance - definition of compensating balance by The Free Dictionary 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. 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. $7,000 / $80,000 = 8.75%. Week 11 Chapters 15, 16, 17, and 18 Quiz .docx, Week 11, Quiz 5 - FIN100 - Principles of Finance.docx. 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 … It's a debt covenant. Question: 15) If A Bank Offers A 10% Discounted Loan With A 5% Compensating Balance, What Is The Effective Rate? A bank loan has a quoted annual rate of 6 percent. The discount would be 2% if paid in ten days or none if paid in 60 (2/10 net 60). Course Hero is not sponsored or endorsed by any college or university. 11.1%; To calculate the effective interest rate on a loan with a compensating balance requirement. In addition to loans, a compensating balance approach may be used to secure a line of credit. The primary objective of such a balance is to reduce the lending cost of a borrower. d. 8.75 percent. For a limited time, find answers and explanations to over 1.2 million textbook exercises for FREE! Compensating Balance. It means the effective loan amount is $45,000 only. The term of the loan is 1 year and interest is due at the beginning of the year. 12) The Stant Shoe Company established a line of credit with a local bank. When a bank issues you a compensating balance loan, it requires that you maintain a bank account there with a minimum balance. The prime rate is currently 8 percent. 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. please show work Tom Sander is a loan officer with Miami National Bank. 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~. After many years in the teleconferencing industry, Michael decided to embrace his passion for @ Babalaas - This creates a tough choice. Bank Two requires Capital to maintain compensating balances equal to 10% of the amount of the line. 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 terms and conditions are as follows: The amount of the loan is $250,000; The loan has a term of 240 days; The interest is paid on a discount basis at an annual interest rate of 15%; The establishment fee is 1% of the loan amount; The compensating balance is $50,000 This would make a loan for $100,000 a better deal with the compensating balance. C) 11.6% . 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. Introducing Textbook Solutions. Choice "d" is correct. The compensating balance loan, on the other hand, will have lower rates but a percentage required to be held as a compensating balance. 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. This question hasn't been answered yet Ask an expert The compensating balance offsets the bank's default risk and can be used to make new loans. 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? @ Glasshouse and Babalaas - You should also take into account what the loan is for. A minimum balance that must be maintained in an account. A compensating balance loan has a 20% compensating balance and an 8% rate. The bank typically charges 8% APR on loans with a compensating balance requirement of 10%. Wikibuy Review: A Free Tool That Saves You Time and Money, 15 Creative Ways to Save Money That Actually Work. present value of its initial investment is called the. d. has an indeterminate effect on. Compensating balance is the least or minimum balance that an organization or an individual needs to keep with the lender. 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. Key Takeaways Agreeing to a compensating balance allows a company to borrow money at a favorable rate of interest. In order to be competitive with other banks, Sanders will adjust the loan rate based on a customer's compensating balance level. 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. D) 12.3% . 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. In addition, the bank requires you to maintain a 15 percent compensating balance in the bank. 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. The compensating balance increases the effective interest rate the loan. The checking account … Compensating balances are minimum balances that may be maintained in an account and still meet the requirements for a loan. The compensating balance is usually 10%. In business finances I often hear about fee added loans versus compensating balance loans with no fees. Explanation. Come and Go Bank offers your firm a discount interest loan with an interest rate of 7 percent for up to $20 million, and in addition requires you to maintain a 4 percent compensating balance against the face amount borrowed. variety of print and online publications, including wiseGEEK, and his work has also appeared in poetry collections, A compensating balance is especially common with corporate loans. Combining positively correlated assets having the … To determine the effective interest rate of a compensating balance loan you just divide the interest rate by one minus the compensating balance represented as a decimal. Which of the following statements is most correct? Effective rate compensating balance = 6%/(1 - 0.2) = 7.5 percent (if c is a 20 percent compensating balance) Effective Interest Rate on Installment Loans Many consumers have installment loans, which are loans that are repaid with a set number of payments. This means an effective interest rate of15% ($1,200,000 interest … 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 maintain a minimum account balance for the loan period. This is because in a fee added loan, the fees are considered a part of the interest. a. raises. No interest is earned on the compensating balance, which is stated as a percentage of the loan. The compensating balance is often used to offset a portion of the cost that a bank faces when extending a loan or credit to an individual or business, and is usually calculated as a percentage of the loan … Compensating balance is the amount of fund that must be withheld at the bank when a loan is originated. By the time the credit line is accessed and drawn on, the balance in the compensating account will be $15,000.00 USD. If a bank offers a 12% discounted loan with a 5% compensating balance, what is the effective rate? c. has no effect on. Bankers often offer this as a means of obtaining a more favorable interest rate on loans extended to existing bank customers. The business borrower must report the … Confidence Bank has made a loan to Risky Corporation. The effective annual interest rate of this loan is Submitted: 15 years ago. e. none of the above. 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 However, the effective interest rate on a loan with a compensating balance is actually higher than a balance-free loan. A bank will usually ask for a minimum credit balance account as compensating balance. Assume a company borrows $50,000 from the bank at … This preview shows page 3 - 6 out of 6 pages. Example: You borrow $ 30,000 at 12%. 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