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Monthly Reducing Balance Method: Simplifying Loan Interest

Monthly Reducing Balance Method: Simplifying Loan Interest

Loans like home and car loans help you achieve significant lifetime milestones like owning a house or a car. However, when you take out a long-term loan, you agree to pay monthly EMIs for many years, which is a significant financial commitment. Without proper financial planning, this commitment can become overwhelming over time.

To effectively plan for loan repayment, you must prepare a financial plan before taking out the loan and be familiar with the various technical terms associated with loans to maximise your savings and repay the loan on time.

One such technical term is the monthly reducing balance method. Did you know that in a monthly reducing balance method of loan interest, the interest is calculated only on the remaining amount? 

Read on to learn more about the monthly reducing balance method, how it is used, its advantages, and how you can leverage it to increase your loan savings.

What is the Monthly Balance Reducing Method?

When you take out a loan, you pay monthly EMIs. There are two components in an EMI. One component reduces the principal amount, while the other goes towards interest payment. There are two ways to calculate the amount of interest to be paid in each EMI.

Most people are familiar with a simple interest or flat-rate method, where the interest component in each EMI is calculated on the same principal amount. The interest component amount remains the same for each EMI.

Another method of applying interest rates to a loan is the monthly balance reducing method. In this case, the interest is applied to the reduced principal amount remaining after the last monthly EMI payment. Hence, the interest component of each EMI is lower than the previous one. Home loans typically offer reduced balance interest, while vehicle loans offer flat-rate interest.

Also, read – Repo Rate Vs Reverse Repo Rate – Meaning & Differences

How is the Monthly Balance Reducing Method Used?

The formula for the reducing balance method is:

Interest amount in EMI=Remaining loan amount x Interest rate

In the monthly reducing interest method, the interest component of an EMI is highest for the first EMI and reduces after that, provided you pay your EMIs on time. Sounds interesting, right? 

Let’s see the concept in action through an example.

Suppose you take a home loan of X amount at 10% interest for 20 years. Your first EMI will be calculated using the entire principal amount X. Let’s assume this first EMI is Y. This Y consists of a principal amount component A and an interest component B. In the next month, the interest will apply to the amount (X-Y), which will cause the interest component in the EMI to be lower than B.

Hence, over the loan tenure, the balance-reducing method incurs less interest than a flat-rate method.

Also, read – How to reduce your home loan interest rate – Tips & strategies

What are the Advantages of the Monthly Balance Reducing Method?

The monthly balance reducing method offers the following advantages:

1. Lower overall interest

The first obvious benefit of the monthly reducing balance method is lower overall interest payments. This benefit saves you considerable money compared to a flat-rate interest method. The slight complexity of EMI calculation for reducing balance method compared to a flat-rate method is not really a disadvantage, as several online EMI calculators also exist for the reducing balance method.

2. Timely payment incentive

Another benefit of the monthly reducing balance method is that it incentivizes timely EMI payments as the interest component goes down with each EMI payment.

3. Better transparency

Once you understand the reducing balance method, you have a better idea of the different components of an EMI and how they are calculated. In this sense, the reducing balance method offers more transparency than a fixed rate method.

4. Flexible management

In a fixed rate method, the loan amount on each EMI is still calculated using the original principal even if you make additional prepayments. However, in the reducing balance method, the additional prepayments reduce the principal amount, reducing the interest component on each EMI. This provides you with more flexibility and freedom with loan repayment.

Also, read – Floating Interest Rate: Definition, Pros, Cons & Calculation

How does the Monthly Reducing Balance Method Affect your Loan?

The monthly reducing balance method affects key aspects of your loan, such as:

1. EMI breakdown

The EMI breakdown is the primary aspect of the loan affected by the reducing balance method. As the loan progresses and each EMI payment is made, more money is contributed to reducing the principal amount than towards interest.

2. Interest burden

When choosing a lender, you first check how much extra money in interest you’ll have to pay. The reducing balance method significantly reduces the additional interest burden with the same interest rate as a flat-rate method.

3. Faster principal repayment

Since more amounts are contributed towards principal repayment with each EMI, a reduced balance method pays off your principal faster than a flat-rate method.

Also, read – Interest Rates Changes and How They Affect Your Loans

How to Maximise Loan Savings with the monthly reducing balance method?

Now that you understand the reducing balance method, let’s see how you can leverage it to maximise your loan savings:

1. Make additional prepayments: To pay even less interest amount in a recurring balance loan, make additional prepayments whenever possible, reducing the principal amount and, hence, the overall interest amount.

2. Choose a shorter loan tenure: With a shorter loan tenure, your principal reduces faster, reducing the overall interest payment.

3. Maintain a good credit score: With a good credit score, you can negotiate and obtain lower interest rates with a monthly reducing balance method.

4. Transfer balance: You can often transfer your remaining loan balance to a different lender with a lower interest rate in many cases, reducing the overall interest payment.

Also, read – Repo Linked Home Loan: Benefits of Home Loans Linked to Repo Rate

How to Calculate Reducing Balance Method for Loan EMI

The reducing balance EMI calculation discussed here is used to find the loan EMI when interest is charged only on the remaining loan amount.

The loan EMI reducing formula is

EMI = [P × R × (1+R)^N] / [(1+R)^N – 1]

where P is the loan amount, R is the monthly interest rate, and N is the loan tenure in months.

With the monthly reducing EMI method, each EMI repays some principal, so the outstanding balance reduces every month. As a result, interest is calculated on a smaller amount over time. Total interest paid is lowered.

Monthly Reducing Interest Rate vs Flat Rate

Understanding reducing rate vs flat rate interest is important when comparing loan options. These two EMI calculation methods differ in the following ways:

FactorFlat RateReducing Rate
CalculationInterest charged on the full loan amount for the entire tenure, even after partial repayments.Interest is calculated only on the outstanding loan balance after each EMI.
EMI EMI remains the same throughout the tenure.EMI may reduce over time as the principal decreases.
Total InterestTotal interest paid is usually higher.Total interest paid is generally lower.
UsesUsed for short-term or small-ticket loans.Preferred for long-term loans like home and personal loans.

With this monthly reducing vs flat interest, EMI, uses, and calculation comparison, making the choice becomes easier.

Monthly Reducing Interest Rate: When to Choose

Knowing when to choose reducing rate can help you save significantly on loan costs. 

One of the key benefits of reducing balance loan is that interest is calculated only on the outstanding principal, which lowers the total interest paid over time. As you repay the loan, the principal reduces. In time, you lower your financial burden. Repayments become manageable.

A reducing interest rate is especially suitable for long-term loans, where interest savings add up over the years. It also encourages early repayment, as any extra payment directly cuts down future interest. 

While the difference may be small (for short-term or low-value loans), choosing a monthly reducing interest rate for higher loan amounts and longer tenures can result in long-term savings.

Also, read – MCLR vs Base Rate – Difference between MCLR and Base Rate

Conclusion

Understanding the EMI calculation in the monthly reducing balance method makes you an intelligent borrower. With this method, you not only pay lower overall interest but also repay the principal amount faster. Most lenders use the monthly reducing balance method on home loans. If you’re looking for a reliable lender to take a housing loan, look no further than Tata Capital.

Tata Capital provides home loans with instant provisional sanction at attractive interest rates. Building a home can be stressful. Don’t let your home loan add to that stress. Choose Tata Capital and embrace a smooth and hassle-free loan experience.

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FAQs

What is the reducing balance method in loan calculation?

The monthly reducing interest rate method calculates interest on the outstanding loan amount after each EMI payment, not the original principal. As you repay the principal every month, the interest portion gradually decreases, reducing total interest costs over the loan tenure compared to flat interest methods.

How to calculate reducing balance method for loan EMI?

 

To answer “how to calculate reducing balance method for loan” you can use this formula: EMI = [P × R × (1+R)^N] / [(1+R)^N – 1]. Here P = principal, R = monthly interest rate, and N = loan tenure in months. You can use an online calculator to make this easier.

What is the major advantage of monthly reducing balance interest rate?

 

One of the advantages of reducing balance method is lower overall interest. It is payable over the loan tenure. Interest is calculated only on the remaining principal each month. So, as repayments continue, the interest amount reduces, making the loan more cost-effective.

Which types of loans usually use the reducing balance method?

 

The reducing balance method is commonly used for long-term loans such as home loans, personal loans, education loans, and auto loans. Advantages of reducing balance method are lower interest costs over extended tenures, as interest decreases with each EMI payment made by the borrower.

Is the reducing method better than the flat rate method?

 

The reducing method is generally better than the flat rate method because interest is charged only on the outstanding loan balance. This reduces total repayment costs, whereas flat rates calculate interest on the full principal, leading to higher overall interest paid.

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