Twenty Percent Rule: What It is, How It Works, Example

What Is the Twenty Percent Rule?

In finance, the twenty percent rule is a convention used by banks in relation to their credit management practices. It stipulates that debtors must maintain bank deposits equal to at least 20% of their outstanding loans. The exact figure used varies depending on interest rates, the perceived creditworthiness of the debtor, and other factors.

Key Takeaways

• The twenty percent rule is a convention used by banks that stipulates the percentage of a loan required to be deposited in a compensating balance account.
• This rule has become less common in recent decades and is often treated flexibly by lenders, varying based on factors such as interest rates and the creditworthiness of the borrower.
• The money held in the compensating balance account will be drawn from the principal of the loan itself and placed in a non-interest-bearing account provided by the lender.
• Banks are free to use these funds for their own lending and investment purposes without compensating the depositor.
• Borrowers cannot use the 20% of the loan earmarked for the compensating balance account but must still pay interest on that portion as it is part of the entire loan.

How the Twenty Percent Rule Works

The twenty percent rule is an example of a compensating balance, a balance held at a bank to reduce the risk of a loan given by that bank. Although in the past, these balances were commonly held at a strict percentage, such as 20%, this is now less common. Today, sizes of compensating balances vary widely and are sometimes waived entirely with the payment of bank service charges or other arrangements.

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

From the borrower’s perspective, this increases the cost of the loan’s capital as the money held in the compensating balance could otherwise generate a positive return on investment. In other words, the opportunity cost associated with the compensating balance raises the cost of capital for the borrower.

From the bank’s perspective, it reduces the effective risk of their loan by holding a significant deposit from the borrower. The bank can also benefit from the return on investment generated from the deposited funds. Borrowers agree to provide a compensating balance when they are unable to find more generous terms elsewhere, such as in instances where the borrower is struggling with liquidity or has a poor credit rating.

Importantly, the interest paid on the loan is based on the entirety of the loan principal, including any amount kept in a compensating balance. For example, if a company borrows $5 million from a bank, requiring a 20% deposit, the interest on that loan would still be based on the full $5 million. Even though the borrower cannot withdraw or invest the $1 million (20%) compensating balance, they must still pay interest on that portion of the loan.

Example of the Twenty Percent Rule

Emily, a real estate developer, seeks to borrow $10 million to finance the construction of a new condominium tower. She approaches a commercial bank that agrees to finance her project under terms that include a twenty percent rule.

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

Although she is only free to use $8 million out of the $10 million she borrowed, Emily must still pay interest on the full $10 million loan. This raises the cost of capital for her loan, while the opposite is true from the bank’s perspective.