Usually, loans are repaid in EMIs or equated monthly instalments. The EMI that you pay depends on the outstanding balance that you have. As you pay off your loan, the outstanding principal will obviously reduce and the interest will be charged on the outstanding balance. Outstanding principal will be calculated using different time periods by different lending companies.
Reducing Balance Loan calculation
The Reducing Balance Method is mainly used to calculate the total interest for housing or mortgage property loans wherein the interest to be paid by the customer is calculated based on the outstanding loan amount after periodic repayments. Being the preferred option compared to the Fixed Interest Rate, Reducing Balance Rate or the Diminishing Rate is used to calculate the interest amount for overdraft facilities and credit cards as well. This method is beneficial to the customers since they have to pay less amount of interest as the loan tenure progresses considering that the interest is calculated based on the outstanding principal loan amount. In this method, the interest decreases after each monthly installment is paid since the remaining balance becomes lesser than the previous month with the payment of each EMI. The depreciation rate percentage is applied on reducing balance of asset.
The formula for the Reducing Balance Method can be represented as,
Amount of interest for each installment = Applicable rate of interest * Remaining loan amount
Suppose, a customer takes a housing loan for Rs.40 lakh with 10% interest rate. The monthly EMI becomes Rs.38,601. Each EMI consists of a percentage of the principal amount that is to be repaid as well as an interest component.
Now, in first month, 10% is charged on the Rs.40 lakh. Out of the total EMI of Rs.38,601, the first month's interest component in the monthly installment is Rs.33,333 and the remaining Rs.5,268 goes towards repayment of the principal. So, at the end of the first month, the remaining balance becomes of Rs.39,94,732 (Rs.40,00,000 - Rs.5,268).
In the second month, 10% is charged on a reduced balance of Rs.39,94,732 and the interest of the EMI becomes Rs.33,289. The remaining Rs.5,311 goes towards the repayment of the principal amount and this continues in following months, till the repayment of the loan is fully completed.
Annual reducing loans use a method in which although the EMI is paid monthly, the adjustment towards principal and interest is made at the end of the year. This method does not work for the borrower’s interest since the lender continues to charge interest on the balance that was outstanding the earlier year even though the principal amount is getting reduced every month. Annual reducing loans are not as common as monthly reducing loans. Monthly reducing cycle, on the other hand, uses a method of calculation where the principal is reduced each time you pay an EMI, and the outstanding balance is used to calculate the interest. Most vehicle, home and personal loans are calculated on a monthly reducing basis.
Daily reducing method is also an option but not necessarily a most principal one. Basically it means that EMI is calculated on the outstanding balance each day. Since most people do not make daily payments, it effectively translates into a monthly reducing balance. Nevertheless, daily reducing cycle does come with its own benefits, particularly if you want to prepay a loan. Let’s take an example to illustrate this. Suppose your due date for EMI is on the 10th of each month, and you make the payment. If you would like to make a partial prepayment for the next month on 15th of the same month you can do so and benefit from it. That because if you have opted for a daily reducing balance, you will get the benefit of the prepayment immediately. The outstanding balance of your loan will get reduced on the 15th of this month instead of the 10th of the next month. In the monthly reducing cycle, your prepayment will be taken into account only when the next EMI is paid.
A borrower’s outgo is lowest in the daily reducing method. Annual reducing method makes the borrower pay almost double the interest one pays on a daily reducing cycle. It is not just the rate of interest that is affected but the cost of loan also depends on the frequency with which balance is reduced. The longer the term loan, the more relevant this becomes.
There are many online EMI Calculators you can use to calculate your EMI for a monthly reducing balance. All you have to do is insert certain information such as Interest Rate (%), amount of loan required, Tenure (in years) and whether the reducing Balance is based on daily, monthly or annual rests. Once this is put in, the EMI will be calculated for your information.
Advantages of the Reducing Balance Method
There are numerous significant advantages to the Reducing Balance Method. Learn about the advantages of the
- This method is simple to implement and easy to understand.
- For businesses, the amount which is charged to the profit & loss account towards depreciation and repairs remains somewhat uniform as the period of the loan progresses.
- The Reducing Balance Method is acceptable for income tax purposes. The depreciation tax deduction can be claimed in a larger amount.
- This method does match the cost and revenue of any business. The greater amount of depreciation during the initial years which is matched against the higher amount of revenue that is generated by the increased production by using a new asset.
Disadvantages of the Reducing Balance Method
There are very few disadvantages of this method which are mentioned in the list below:
- The Reducing Balance Method charges a heavy amount of depreciation during the initial years.
- The rate of depreciation can only be calculated if there is some residual value of the asset.
It is always very important to know how to calculate the amount of interest for a loan product so as to learn how your loan will progress over the years and how much money you will be paying towards the interest of a loan. This is also helpful while comparing the loans through the Reducing Balance Method and the Fixed Interest Method and can help you make an informed decision depending on your situation. The Reducing Balance Method has more to offer than a Simple Interest Method but still its terms and conditions depend on the lender.