A business loan quoted at 8% can cost 10% of the cash it actually supplies. The difference sits in the deposit agreement: if the borrower must leave part of the advance at the bank, comparing interest rates alone prices money the business cannot spend.
That is the economic question behind a compensating balance. The Federal Reserve describes it as a deposit maintained to compensate a bank for credit, with arrangements ranging from informal understandings to formal contracts. Some depend on an average balance rather than a sum locked away continuously.[1] The label therefore starts the valuation; the agreement determines the calculation.
Follow the spendable money
Consider a hypothetical wholesaler borrowing $100,000 for one year, with principal and interest payable at maturity. The annual interest rate is the quoted 8%, but the lender requires a 20% compensating balance throughout the loan. Assume that balance earns nothing, comes entirely from the advance and becomes available for repayment at maturity. There are no fees, taxes or interim payments in this illustration.
The bank advances the full loan. The wholesaler leaves the required share on deposit and has $80,000 available to buy inventory, cover freight or meet payroll. Interest nevertheless accrues on the full borrowing, producing an $8,000 interest bill.
The relevant comparison is therefore:
Annual financing cost on usable funds = interest paid ÷ cash available to the business = $8,000 ÷ $80,000 = 10%.
This is the author's calculation from the stated assumptions. AccountingTools explains the underlying mechanism: a borrower pays interest on the gross loan while the compensating balance reduces the amount effectively available, raising the cost relative to that usable amount.[2]
The deposit has not disappeared. At maturity, it is released and helps repay the principal. The financing cost comes from carrying debt on money that was unavailable during the year. Deducting the deposit from usable proceeds and also treating the entire deposit as an expense would count the same restriction twice.
Following the cash through repayment makes the distinction clear. The wholesaler must return the loan principal plus interest, but can apply the released deposit toward that payment. Its operating business has had the use of $80,000 and must provide that amount back, plus the interest bill. The 10% result describes those cash flows; it does not imply that the bank changed its contractual rate.
Compare loans that solve the same problem
Suppose the wholesaler actually needs the entire headline advance for stock. This facility falls short even though its face amount appears sufficient. The company would have to negotiate a larger loan or supply cash from elsewhere.
For the simplified agreement above, the amount to borrow is the desired usable cash divided by the share of the loan that can leave the bank. Increasing the advance also increases the required deposit. Borrowing only the initial shortfall would still leave a smaller shortfall behind.
This is why competing offers should be sized to deliver the same usable cash on the same dates. A loan with a higher stated rate and no deposit requirement could be cheaper, provided its cost remains below the adjusted cost of the restricted offer. A lower coupon can also be a fair bargain if it compensates sufficiently for the deposit requirement.
Payment timing belongs in that comparison. Our calculation works because everything stays constant and settles after a full year. Monthly interest, changing drawings or an upfront fee require the actual dated cash flows. A revolving facility cannot be valued reliably by dividing a year's interest by a convenient year-end balance.
The strongest counterweight is cash already there
The example assumes every dollar of the required deposit is additional. Real businesses also hold cash to meet bills, absorb surprises and act on opportunities. OpenStax distinguishes those operating motives from a bank-imposed compensating balance.[3]
That distinction can change the result. If the bank accepts an average operating balance the wholesaler would have maintained anyway, meeting the requirement may leave all the new loan proceeds available for their intended purpose. Applying the example's full deduction mechanically would then overstate the incremental restriction.
But money used repeatedly for payroll is not automatically available to satisfy a permanent minimum. An average-balance agreement and a floor that must hold every day can have very different effects during a seasonal cash squeeze. The comparison needs the company's cash calendar and the agreement's measurement rule, not just today's account total.[1][3]
Deposit earnings can also offset financing expense. Include interest actually earned and fees actually avoided, while checking what the same funds could earn or accomplish elsewhere. A balance the company would willingly hold at the same bank on the same terms carries a different incremental cost from cash moved out of a better-paying account solely to secure the loan.
The falsifier is concrete: the claim that this balance requirement makes the cheaper-looking offer more expensive fails if a comparison of actual incremental cash flows, including deposit income and fees, gives it the lower financing cost. The worked result establishes a mechanism, not a verdict on every banking relationship.
Read the cash note, then the calendar
For companies reporting under the relevant SEC balance-sheet rule, restrictions on cash require disclosure. The rule also calls for notes describing compensating-balance arrangements that do not legally restrict withdrawal, and arrangements supporting future credit availability.[4] An investor therefore needs to read beyond the cash total: accounting presentation and practical freedom to deploy money answer related but different questions.
Three events would confirm or break the initial valuation:
- At signing and first draw: reconcile the advance with the deposit requirement, its measurement period and its release terms. Establish how much cash reaches operations.
- At the first balance-measurement date: compare the required balance with the cash the business would otherwise have held, including its payroll trough. Check actual deposit earnings and charges.
- At renewal or repayment: verify when the deposit becomes freely available and compare replacement offers for the same usable funds. A rate reduction matters only alongside any change in the cash it buys.