# How to calculate the compensation balance interest rate for installment loan?

## How to calculate the compensation balance interest rate for installment loan?

An offsetting balance is an account balance that a bank can use to offset loan defaults. Installment loans need an offsetting balance and will have a higher effective interest rate than loans without this feature. Calculating the interest rate on an offsetting balance and installment loan will help you understand the true cost of debt.

If your loan is "discounted," this means that the lender will require upfront interest at the end of each period. Those with a discount loan have an additional step required to complete the effective interest calculation.

### Installment loan with compensating balance

Look at your loan documents to determine the principal amount of the loan, the required offset balance, and the stated interest rate. The offsetting balance is typically expressed as a percentage of the loan principal, but some lenders may indicate a fixed dollar value.

Calculate the nominal interest. This is done through the option of the established interest rate and multiplied by the principal value. For example, if you have a loan of \$ 100,000 with an interest rate of 10 percent and an offsetting balance of 5 percent, the nominal interest would be \$ 10,000 (\$ 100,000 x 10 percent).

Calculate the required offsetting balance. If you have a fixed amount of money for the compensation balance, this step is now complete. If you have a necessary compensation balance for a certain percentage, having that percentage multiplies by the indicated one. Using the same example above, the required compensation balance would be \$ 5,000 (\$ 100,000 x 5 percent).

Calculate the principal available. This is done by subtracting the required offsetting balance from the previously established value of principal on the loan. Using the same example, the direct available would be US \$ 95,000 (\$ 100,000 - \$ 5,000).

Divide the nominal interest by the direct available. This is the effective interest rate and the true cost of the debt. In this example, the effective interest rate is 10.53% (\$ 10,000 / \$ 95,000).

### Installment loan discount with offsetting balance

Follow steps one through three for installment loans in the offsetting balance section.

Calculate the principal available. This is done by taking the total principal amount and subtracting the nominal interest and the compensation balance. Using the same example above, the direct available will be: US \$ 85,000. (US \$ 100,000 - US \$ 10,000 - US \$ 5,000)

Divide the nominal interest by the direct available. In this example, the effective interest rate turns out to be 11.76 percent (\$ 10,000 / \$ 85,000).