What Is an Earnings Allowance?
An earnings allowance is a calculation of the net funds available in a checking account, and the credit amount can be used to offset all or a portion of monthly service charges.
In other words, it is the baseline amount that a customer must have in his or her demand deposit account in order to avoid accruing monthly service fees.
- An earnings allowance refers to a minimum account balance allowed for a depositor, below which fees will be charged.
- The amount allowed will vary by bank and is provisioned an implicit interest rate known as the earnings credit rate (ECR).
- Because banks can charge maintenance fees for balances that drop below the earnings allowance threshold, depositors must decide whether it is worth keeping larger deposits at banks.
How Earnings Allowances Work
The rate for the earnings allowance, or earnings credit rate (ECR), is set at the bank's discretion. The ECR amounts to a calculation of the return that a bank’s customers earn on any funds held in the bank overnight. But instead of paying this return back to customers in the form of interest payment, the bank gives it to them in the form of an earnings credit allowance that is then applied to offset the cost of any fees or service charges the bank generally imposes.
ECRs and earnings allowances allow banks to reduce operating costs while minimizing fee burdens for the customer. It further allows customers to maintain access to their liquid assets throughout the banking day. Earnings allowances also allow banks to maintain a certain level of liquidity in order to mitigate financial risks.
To understand how the earnings allowance is calculated, let’s look at the example of Company F. Company F has a demand deposit account with Bank X. Bank X will apply its ECR to determine the earnings allowance for this account. The ECR will take into account the rate at which Company F uses the bank’s services, and then calculate the earnings allowance for that account daily. The ECR is usually based on a percentage of 13-week Treasury bill rates.
How Business Customers Use Earnings Allowances
Because each bank sets its own earnings allowance, the amount of said allowance can vary a lot from one bank to the next. Individual customers have to decide how they will best make use of their bank’s earnings allowance. Accounts with high balances tend to have higher earnings allowances, which can translate to lower banking service fees for the account holder.
As a result, business customers must decide if they want to avoid banking fees by keeping large balances in demand deposit accounts, or maximize operational efficiency by using the cash they have on hand and paying the banking fees. Usually, business customers try to strike a balance between having the cash they need for operational expenses on hand and minimizing account fees via the earnings allowance.