Legal Definitions - compensating balance

A compensating balance is the minimum amount of money that a borrower must keep on deposit with a bank as a condition for a loan or a line of credit. This balance is usually a percentage of the loan amount and is held in a non-interest-bearing account.

Let's say a business wants to borrow $100,000 from a bank. The bank may require the business to maintain a compensating balance of 10%, or $10,000, in a non-interest-bearing account for the duration of the loan. This means that the business can only use $90,000 of the loan proceeds and must keep $10,000 on deposit with the bank.

Another example is a personal line of credit. If a person wants to open a line of credit with a bank, the bank may require them to maintain a compensating balance of 5% of the credit limit. For instance, if the credit limit is $10,000, the person must keep $500 on deposit with the bank.

These examples illustrate how a compensating balance works. It is a way for banks to ensure that borrowers have a vested interest in repaying their loans and to offset the risk of lending money.