20% Rule

What Is the Twenty Percent Rule?

In finance, the 20% rule is a convention utilized by banks comparable to their credit management practices. In particular, it specifies that debtors must keep up with bank deposits that are equivalent to somewhere around 20% of their outstanding loans. In practice, the specific figure utilized differs relying upon interest rates, the perceived creditworthiness of the debtor, and different factors.

How the Twenty Percent Rule Works

The 20% rule is an illustration of a compensating balance; that is, a balance held at a bank for the motivations behind diminishing the risk of a loan given by that bank. Albeit in the past it was commonplace for these balances to be held at a severe percentage, for example, 20%, this has become more uncommon in recent many years. Today, the spans of compensating balances will generally run widely and are in some cases even deferred completely with the payment of bank service charges or other such arrangements.

Generally, the money held in the compensating balance account will be drawn from the principal of the loan itself, where it is then positioned in a non-interest-bearing account given by the lender. The bank is then free to involve these funds for its own lending and investment purposes, without compensating the depositor.

According to the point of view of the borrower, this addresses an increase in the cost of capital of the loan on the grounds that the money being held in the compensating balance could somehow be utilized to produce a positive return on investment. As such, the opportunity cost associated with the compensating balance raises the cost of capital for the borrower.

According to the viewpoint of the bank, the inverse is true. By holding a critical deposit from the borrower, the bank diminishes the effective risk of their loan while likewise profiting from the return on investment which they can produce from the deposited funds. Naturally, borrowers will possibly consent to give a compensating balance when they are unable to find more liberal terms somewhere else, for example, in cases where the borrower is battling with liquidity or has a poor credit rating.

Significantly, the interest paid on the loan depends on the entirety of the loan principal, incorporating any amount kept in a compensating balance. For instance, assuming a company borrows $5 million from a bank under terms that expect it to deposit 20% of that loan at the lending bank, then the interest on that loan would nonetheless be founded on the full $5 million. Even however the borrower is unable to pull out or invest the $1 million (20%) compensating balance, they would in any case have to pay interest on that portion of the loan.

Illustration of the Twenty Percet Rule

Emily is a real estate designer seeking to borrow $10 million to finance the construction of another condominium tower. She moves toward a commercial bank that consents to finance her project under terms that incorporate a 20% rule.

Under the terms of her loan, Emily is required to deposit $2 million from the $10 million loan into a non-interest-bearing account held at the lending bank. The bank is then free to invest or loan those funds without paying Emily any interest on her deposit.

Despite the fact that she is simply free to utilize $8 million out of the $10 million she borrowed, Emily nonetheless must pay interest on the full $10 million loan. Effectively, this raises the cost of capital of her loan, while the inverse is true according to the bank's point of view.

Features

• This rule has become more uncommon in recent many years, and is frequently treated deftly by lenders, and shifts in view of various factors, for example, interest rates and the creditworthiness of the borrower.
• The 20% rule is a convention utilized by banks that specifies the percentage of a loan that is required to be deposited in a compensating balance account.
• The money held in the compensating balance account will be drawn from the principal of the loan itself, where it is then positioned in a non-interest-bearing account given by the lender.
• Banks are then free to involve these funds for their own lending and investment purposes, without compensating the depositor.
• A borrower can't utilize the 20% of the loan reserved for the compensating balance account yet nonetheless must pay interest on that portion as it is part of the whole loan.