What is the monthly reducing balance method for calculating interest?
January 17, 2022
Financial institutions use the Monthly Reducing Balance Method for calculating interest on Home Loans. Read this post to know what this method is, and how
If you’re about to take a housing loan to purchase your dream home, we think it’s wise to know as much about the loan as possible. The interest makes up for a significant portion of the total amount a borrower repays to the lender, over the loan tenure.
Lenders use the Monthly Reducing Balance Method for calculating the interest on Home Loans. So what is this method and how do lenders use it? Take a look –
What is Monthly Reducing Balance Method?
Most housing loans offered by banks and other financial institutions in the country are Reducing Balance Loans. In this method, the interest is calculated as per the outstanding principal amount after each repayment. Every time you pay an EMI, the outstanding loan amount falls.
So, if you’re paying monthly EMIs on your housing loan, the lender will calculate the interest after every payment on the reduced outstanding amount. This is why the interest component is the highest at the start of a repayment cycle. As the outstanding principal falls after every payment, so does the interest component in the EMI amount.
How is Monthly Reducing Balance Method Used?
The Reducing Balance Interest Formula is as follows-
Interest Amount in Each EMI = Remaining Loan Amount x Rate of Interest
Here’s an example to help you understand how lenders use this method -
Let us assume that a borrower has taken a loan of Rs 50 lakh @8% for 20 years. The EMI amount would be Rs 41,822. The EMI amount consists of the principal component and the interest component.
Here is a brief overview of how interest will be calculated using the Reducing Balance Method.
- First Month
In the first month, the interest would apply to the entire outstanding amount of Rs 50 lakh. So, the interest component in the EMI amount of Rs 41,822 will be Rs 33,333 while Rs 8,488 will be the principal component.
- Second Month
In the following month, the interest would be applicable on Rs 4,958,178 (total outstanding - EMI paid). So, while the EMI amount would remain the same at Rs 41,822, the interest component will fall to Rs 33,276, and the principal component will increase to Rs 8,545. The cycle will continue throughout the loan tenure.
As manual calculations can be challenging, you can use a Reducing Balance EMI calculator to understand how the calculation will work out for your Home Loan.
Why is the Reducing Balance Method better than the Fixed-Rate Method?
In the Fixed-Rate method, the interest is calculated on the entire loan amount. Unlike the reducing balance method, the principal amount is not adjusted after repayments. So, you’ll continue to pay the same interest amount every month, throughout the loan tenure.
The Reducing Balance Loan formula calculates the interest on the outstanding balance and not on the entire loan amount. As a result, the total interest outflow on your Home Loan repayments is lower in Reducing Balance loans, than in Fixed-Rate loans. Most housing loans in the country use this method. However, loans like Vehicle Loans and Personal Loans use the Flat-Rate method.
Maximum Interest Savings with Monthly Reducing Balance Method
Now that you know the EMI Reducing Balance Method formula and how lenders use it, you are one step closer to becoming a savvy borrower. Try to learn more about housing loans and their repayment, to avoid any discrepancies in the future.
Repay your loan on time as each repayment impacts the interest outflow and your ability to take maximum advantage of this interest calculation method.