c) Effective interest rate = 11% (None of the $800,000 borrowed is required to meet the balance request.) Suppose a clothing store needs a line of credit of $100,000 (LOC) each month to manage its operating cash flow. The store plans to use the LOC to buy inventory at the beginning of the month and then pay the balance with the money brought in by sales throughout the month. Let`s take the following example: a borrower receives a $5 million loan at an interest rate of 4.5%. Annual interest payments were $225,000. The bank`s balancing requirement is $2 million. In reality, the borrower borrows $3 million ($5 million loan minus $2 million settlement balance). Thus, the effective interest rate is 7.5%. Since the cost of waiving the discount is higher than the cost of borrowing for a short-term loan, Erica is right; their boss is wrong. For example, a business has a $5 million line of credit with a bank. The credit agreement states that the company will hold a settlement balance in an account with the bank of at least $250,000. If both parts of the agreement are cleared, the loan is actually $4,750,000. The two most common types of compensation agreements that banks use are the average balance and the minimum fixed amount.

The average balance agreement is most commonly used in commercial banking lines of credit and is calculated based on the average account balance over a period of time, usually an average of 30 days. Usually, when insufficient balances are lower than the agreed average balance, the interest rate on the loan increases. The implementation of the agreement is simplified if the promoter maintains an existing deposit account relationship with the bank. Since the agreement is enforceable and liquidity is limited, disclosure must be made in the borrower`s annual financial statements and in the promoter`s personal financial statements. Often, the bank`s balancing needs become higher when the available liquidity is higher, which further increases the effective cost of borrowing. Accepting a balancing balance can allow a company to borrow at a favorable interest rate. The general belief in financing commercial real estate – especially by bank loan agents to their customers – is that if the commercial real estate borrower enters into a settlement agreement with the bank, the borrower will benefit from a lower interest rate on the loan. Since the store requires the cash balance of $20,000 for other expenses, the owner borrows $40,000 from the LOC to purchase inventory. Most customers pay in cash or by credit card, so the LOC can usually be refunded in the last week of the month. .