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.
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.
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.
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.
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.
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.
25 November 2024
6 mins read
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