Allow me to tell you a story about ‘reducing balance loan calculation’.

Why I’m writing a blog post about it?

Because it helped me and my friend to see the *reducing balance method* in a perspective of **cheap vs costly loans**.

First, I’ll tell you the story.

Then we will dig deeper into the reducing balance method of loan calculation.

That will explain how reducing balance method makes loan cheaper. Read more about how to prepare for loan application.

### The Story

One day my friend got a call from a bank.

He was told that the bank can offer personal loan @8.5% p.a. interest.

My friend was surprised. Why? Because normal personal-loan rate prevailing at that time was 14%+ per annum.

Hence my friend concluded that the call was spammy. [Read more about 5 Ways to Earn Higher Interest on FD’s]

But before he could disconnect the call, the bank personnel made two statements:

– Bank can offer loan @8.5% at ‘

fixed interest rate‘.– Bank can offer loan @14.88% at ‘

reducing balance rate‘.

Though these two statements made my friend even more confused, but he could say that at least the call is not spammy.

Anyways, he disconnected the call and reached me. Together we did some research. About what?

Why bank is offering such two distinct interest rates on the same loan?

## Fixed Interest vs Reducing Balance method

The bank was ready to offer personal loan @8.5% p.a., right?

When the market rate was 14%+, how bank was offering such low interest rates?

Actually the answer was hidden in the *two statements* made by the bank’s executive.

What we commonly see around is the ‘interest rates’ when loan calculation is done by ‘reducing balance method’.

But here 8.5% was offered at ‘fixed interest method’. [*Falling interest rates are not always bad: Read more about Dosa Economics of Raghuram Rajan*]

### #1. Fixed interest loan calculation…

Let’s see this example to know what is ‘fixed interest rate method’.

Suppose one took a personal loan of Rs.1,00,000, at 8.5% interest (@fixed rate) for 1 year.

The loan calculations will be as below:

Things to note in the above calculation:

**Interest Payable**: The total interest payable calculation is simple. But on downside, this simplicity makes the ‘fixed interest loans’ expensive for the borrowers. Calculation: Rs.1,00,000 x 8.5% x 1 year = Rs.8,500. Read about transfer of home loan for lower interest rates.**Total Payment**: The borrow has to repay the loan principal along with the interests for 1 year. Hence, the total payment due will be Rs.1,08,500 (Rs.1,00,000 + Rs.8,500). Read more about how to identify a debt trap.**Monthly Payments (EMI)**: The borrower has to pay Rs.1,08,500 in equal instalments paid each month. How many month the borrow has in hand? 12 months (1 year x 12 month). Hence, EMI (monthly payments) will be Rs.9,042 (Rs.1,08,500 / 12). Read more about habits of people with high credit score.

### #2. Reducing balance loan calculation

Here we will understand the difference between ‘fixed rate’ and ‘reducing balance rate’.

Let’s take the above example (in #1), but this time instead of interest rate being **fixed**, it will be **reducing balance**.

Loan of Rs.1,00,00 taken @8.5% interest (reducing balance) for 1 year.

This will be the loan calculation here:

Things to note in the above calculation:

**Monthly EMI**: In reducing balance method, interest calculation is complicated. Hence, we are using Excel to do the computation. First we will calculate the EMI. EMI calculation can be done using Excel’s PMT formula. Please note the difference in EMI between fixed (Rs.9,042) and reducing balance method (Rs.8,722). Read more about whether to invest money or use it to prepay loan?**Lower EMI:**In reducing balance method, the EMI is lower than fixed interest method. Why? Because unlike fixed interest method, here the interest calculation is done each month. As loan outstanding reduces each month, hence the borrower pays less interest each passing month. Read more about what to do when EMI is high.

Confused? Allow me to explain the reducing balance method of interest calculation using examples.

## EMI Calculator: Reducing Balance Loan Vs Fixed Interest Loan

#### Reducing Balance Loan Calculator

Principal Loan Amount (Rs.) | |

Interest Rate (%) | |

Time (in months) |

Total Interest (Rs.) :.. | |

Total Payment (Rs.) :.. | |

Monthly EMI (Rs.) :.. |

#### Fixed Interest Loan Calculator

Principal Loan Amount (Rs.) | |

Interest Rate (%) | |

Time (in years) |

Total Interest (Rs.) | |

Total Payment (Rs.) | |

EMI (Rs.) |

## Why in reducing balance method EMI is less?

For borrowers, reducing balance method is economical. How? Because they have to pay less EMI’s.

Why EMI is less? Because of the way the interest calculation is done.

To understand this, let’s take a simple example.

Loan of Rs.100,000 taken at 8.5% p.a. interest (reducing balance rate) for one year (12 months).

##### Calculation: Reducing balance method

Check how interest load gets lowered each month. How?

This happens because the interest calculation in done on the “loan balance” available that month.

As loan balance is reducing every passing month, interest on loan is accordingly reducing.

But this is not the case with ‘fixed interest method’. There the interest load remains the same even if the “loan balance” is falling.

##### Calculation: Fixed Interest method

Check how interest load remains same each month. Why?

This happens because the interest calculation in done based on the loan balance in the starting month.

No matter if the loan balance is reducing with EMI’s being paid, but the payable interest remains the same.

**Comparison between Reducing Balance and Fixed Interest calculations**

SL | Description | Reducing Balance Loans | Fixed Interest Loans |

1 | Offered Interest Rates on Loans | Higher | Lower |

2 | Calculation Process of Total Interest Payble on Loan | Complicated | Simple |

3 | Interest paid each month | Reduces with time | Remains constant with time |

4 | Interest calculated on which loan balance | Based on reducing loan balance | Based on loan balance of the first month |

5 | Principal paid | Same | Same |

6 | Total Interest Paid | Lower | Higher |

7 | Monthly EMI’s | Lower | Higher |

## Explanation: 14.88% Interest Vs 8.5% Interest rates…

Coming back to the story which was narrated in the beginning of the blog post.

Banks were ready to offer loan to my friend at two drastically different interest rates:

**@8.5% p.a**: Loan offered at Fixed Interest.**@14.88% p.a**: Loan offered at Reducing Balance Interest.

What was the logic of this loan offering? How the bank was able to offer such low interest rates?

The bank’s could offer such low interest (8.5% vs 14.88%) because they were making anyhow the same amount of money.

Check the interest calculation shown below:

Take-away’s from the above table:

**Reducing Balance Loan**: Though the visible interest rate of reducing balance loan is higher, but over a period of time, total payable by the borrower (principal + interest) is small.**Fixed Interest Loan**: Though the visible interest rate of fixed interest loan is small, but over a period of time, total payable by the borrower (principal + interest) is high.

## Conclusion

Reducing balance method is a more borrower friendly approach of interest calculation on loans. Why it is so?

Because when we pay EMI each month, there is a simultaneous reduction in loan balance. When loan balance reduces, the accrued interest must also fall.

Reducing balance method uses this philosophy to calculate the payable interest.

I hope I was able to give you a decent idea about the reducing balance method of loan calculation.

In case you have any query/feedback – please post it in the comment section below.

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