Compensating balances – cost of funds?

  • This topic has 14 replies, 3 voices, and was last updated 10 years ago by Anonymous.
  • Creator
    Topic
  • #184440
    Anonymous
    Inactive

    Hello everyone,

    I am confused on how does compensating balance work.

    In some of the MCQ for Becker, it usually mentions “cost of funds is x %”.

    But what exactly do they mean by “cost of funds”? and how does this apply to compensating balance?

    For example, if cost of funds is 10% and the minimum (compensating) balance is 5,000 and you have 0$, it will be a cost of $500?

Viewing 14 replies - 1 through 14 (of 14 total)
  • Author
    Replies
  • #531806
    Anonymous
    Inactive

    A compensating balance is an amount that the bank makes you hold in a savings account or separate account during a loan term. It's a debt covenant. 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. So if your cost of funds is 10% and you have a compensating balance of $5,000, then the cost of the loan that you originally made is increased by $500. Lets say your loan was $1,000,000 at 10% interest for one year. 1,000,000 X .10 X 365/365 (Principle X Interest X time) = 100,000. So the cost on the loan you made isn't 100,000 (the interest cost), it is $100,500. The $500 is an opportunity cost. The effective interest on the loan isn't the stated 10%, it is actually 100,500 / 1,000,000 = 10.05%.

    Make sense? I'm trying to eat supper and answer this at the same time so, everyone check me on this.

    #531827
    Anonymous
    Inactive

    A compensating balance is an amount that the bank makes you hold in a savings account or separate account during a loan term. It's a debt covenant. 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. So if your cost of funds is 10% and you have a compensating balance of $5,000, then the cost of the loan that you originally made is increased by $500. Lets say your loan was $1,000,000 at 10% interest for one year. 1,000,000 X .10 X 365/365 (Principle X Interest X time) = 100,000. So the cost on the loan you made isn't 100,000 (the interest cost), it is $100,500. The $500 is an opportunity cost. The effective interest on the loan isn't the stated 10%, it is actually 100,500 / 1,000,000 = 10.05%.

    Make sense? I'm trying to eat supper and answer this at the same time so, everyone check me on this.

    #531808
    Anonymous
    Inactive

    Thanks, that makes sense!

    So the 10% cost of funds is basically saying the opportunity that is lost (cost) if there wasn't a compensating balance?

    And for the calculation for effective interest rate is net cash outflow/net cash inflow?

    #531829
    Anonymous
    Inactive

    Thanks, that makes sense!

    So the 10% cost of funds is basically saying the opportunity that is lost (cost) if there wasn't a compensating balance?

    And for the calculation for effective interest rate is net cash outflow/net cash inflow?

    #531810
    Anonymous
    Inactive

    I think you've got it now. You really should check my formula for the effective interest. Like I said, it's nearly 9pm here and I'm just now eating supper. Tired and hungry CPA trying to work BEC problems is probably not a good idea.

    #531831
    Anonymous
    Inactive

    I think you've got it now. You really should check my formula for the effective interest. Like I said, it's nearly 9pm here and I'm just now eating supper. Tired and hungry CPA trying to work BEC problems is probably not a good idea.

    #531812
    NYCaccountant
    Participant

    For the effective rate, you would subtract the compensating balance, correct? Because you don't have access to those funds, the loan balance is technically 900,000. so the effective rate would be 100,000/900,000=11%? I'm not sure but thats what's making sense in my head right now.

    AUD - 99
    BEC - 84
    FAR - 93
    REG - 87
    NYC born and raised.

    FAR - 93
    REG - 87
    BEC - 84!!!!
    AUD - 99!!!!!! CPA exam complete.

    #531833
    NYCaccountant
    Participant

    For the effective rate, you would subtract the compensating balance, correct? Because you don't have access to those funds, the loan balance is technically 900,000. so the effective rate would be 100,000/900,000=11%? I'm not sure but thats what's making sense in my head right now.

    AUD - 99
    BEC - 84
    FAR - 93
    REG - 87
    NYC born and raised.

    FAR - 93
    REG - 87
    BEC - 84!!!!
    AUD - 99!!!!!! CPA exam complete.

    #531814
    Anonymous
    Inactive

    Haha, yeah.

    Thanks again for your help! I'll check over some of my MCQs when I review again.

    #531835
    Anonymous
    Inactive

    Haha, yeah.

    Thanks again for your help! I'll check over some of my MCQs when I review again.

    #531816
    Anonymous
    Inactive

    Thank you NYCAccountant! I didn't think my formula was right.

    #531837
    Anonymous
    Inactive

    Thank you NYCAccountant! I didn't think my formula was right.

    #531818
    Anonymous
    Inactive

    Ohh, I see. Thanks!

    I need to make a note of these other formulas.

    #531839
    Anonymous
    Inactive

    Ohh, I see. Thanks!

    I need to make a note of these other formulas.

Viewing 14 replies - 1 through 14 (of 14 total)
  • You must be logged in to reply to this topic.