The Reducing Balance Method is principally used to estimate the total interest for housing or mortgage property loans where the interest to be paid by the borrower is determined based on the outstanding loan amount after the periodic repayments. Being the favored option compared to the Fixed Interest Rate, Reducing Balance Rate or Diminishing Interest Rate is used to gauge the interest amount for overdraft facilities and credit cards. This method is advantageous to customers since they will be required to pay a lesser amount absolute interest as the loan tenure advances considering that the interest is computed based on the outstanding principal loan. In this method, the interest diminishes after each monthly installment, because the remaining balance becomes lesser than the preceding month with the payment of every EMI. The percentage of depreciation is applied on the reducing balance of the asset.
The formula for the Reducing Balance Method can be given as,
Amount of interest for each instalment=Applicable rate of interest * Remaining loan amount
Typically, loans are repaid in the form of EMIs. The EMI that you can pay depends on the outstanding balance of the loan taken. As you pay off the loan you have received, the outstanding principal will naturally reduce, and the interest will be imposed only on the outstanding amount of loan. The outstanding principal is estimated by using distinct periods by different lending corporations.
Annual reducing loans employ a method in which the adjustment of principal and interest is made at the end of each year. This method doesn't work for the borrower's interest since the lender keeps charging the interest on the outstanding loan amount. Annually reducing loans aren't as common as the monthly reducing loans. Monthly reducing cycle or the reducing balance scheme, on the other hand, adopts a method of computation where the principal is reduced every time the borrower pays an EMI, and the outstanding balance is used to gauge the absolute interest. A vehicle, home, and personal loan are calculated based on reducing balance scheme.
The daily reducing method is also an alternative, but it isn't necessarily an ideal method. It indicates that the EMI is determined on the outstanding balance for each day. Since most people don't make daily payments, it adequately translates into a monthly reducing balance. Nevertheless, the daily reducing cycle comes with its benefits, mainly if you want to prepay a loan.
A borrower's expenses are lowest in the daily reducing method. The annual reducing method offers the borrower to pay almost the double amount of interest that one spends on a daily reducing cycle. The rate of interest and the cost of the loan depend on the frequency with there is a reduction in the balance. The longer is the tenure of the loan, the more the frequency becomes essential.
You can use the online EMI Calculators to calculate your EMI for the monthly reducing balance. You will be required to insert information such as the interest rate, loan amount and the tenure and the method under which the interest on loan amount is calculated. After you have provided the information, the EMI calculator estimates the amount payable each month under the EMI scheme.
Advantages of the Reducing Balance Method
Below listed are the advantages of the Reducing Balance Method
- The method is easy to comprehend.
- For large businesses, the interest amount charged on the profit and losses incurred by the company remains uniform throughout the tenure.
- The Reducing Balance Method is also beneficial for tax deductions. The reduction in the form of a tax deduction is much higher under the reducing balance method.
Disadvantages of the Reducing Balance Method
The disadvantages of the reducing balance method are listed below
- A hefty amount of depreciation is charged during the initial period.
- The rate of depreciation is estimated only if there is a residual value of the asset
- It is imperative to know how to determine the amount of interest for a loan product to learn how your loan will grow over the years and how much money you will be liable to pay in the form of interest. This is also beneficial while analyzing the loans through the Reducing Balance Method and the Fixed Interest Method. This could help the borrower in making an informed decision.