How the Monthly Reducing Balance Method Affects Your Loan Interest

Taking out a home loan is a significant financial commitment. While EMIs (Equated Monthly Instalments) help spread repayments over time, the method used to calculate interest can substantially affect the total amount you repay. One commonly used method is the monthly reducing balance method – a smart option often used in home loans.
In this article, we’ll break down what the monthly reducing balance method is, how it works, and how it can impact your finances.

What Is the Monthly Reducing Balance Method?

The monthly reducing balance method, also sometimes referred to as the reducing interest rate method, calculates interest on the outstanding loan principal – not the original loan amount. 
In simple terms, the interest is recalculated each month based on the remaining loan balance after you've made your EMI payment.
This method is commonly used in home loans and can result in significant savings in overall interest costs over time compared to flat-rate interest methods.

How the Monthly Reducing Balance Method Works

Here’s how it works: each EMI you pay consists of two components – interest and principal. With every payment, the principal reduces, and interest for the next month is calculated on this new, lower balance.
For example, if you take a home loan of INR 30 lakh at a 10% annual interest rate, your first EMI will have a higher interest component. From the second EMI onwards, the interest is calculated on the reduced balance, so the interest portion gradually decreases while the principal portion increases.

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Advantages of the Monthly Reducing Balance Method

• Lower Total Interest
  One of the biggest benefits of this method is that you end up paying less total interest over the life of the loan, especially if you make timely EMI payments.
• Encourages Timely Payments
  Since interest reduces every month, borrowers are incentivised to pay EMIs on time to benefit from lower interest costs over time.
• Better Transparency
  This method provides better visibility into how your EMI is split and how your principal is reducing with each payment.
• Flexibility in Loan Management
  Any prepayments you make directly reduce the outstanding principal, leading to even lower interest charges on subsequent EMIs.

Example of the Monthly Reducing Balance Method

Let’s say you take a home loan of INR 20 lakhs at a 10% annual interest rate for 15 years. Your monthly EMI is approximately INR 21,500. Month 1:

• Interest is calculated on the full INR 20 lakhs:
  INR 20,00,000 * (10% ÷ 12) = INR 16,666
• From your EMI of INR 21,500:
  INR 16,666 goes towards interest, and the remaining INR 4,834 (21,500 - 16,666) goes towards reducing your principal.

Month 2:

• New loan balance: INR 20,00,000 - INR 4,834 = INR 19,95,166
• Interest this time: INR 19,95,166 * (10% ÷ 12) = INR 16,626. Now, a slightly larger portion of your EMI goes towards principal repayment.

With each passing month, your interest portion decreases, and your principal repayment increases.

Conclusion

Understanding the monthly reducing balance method can result in more informed financial planning. Since interest is calculated on the reduced principal each month, this method can result in lower total interest payments and faster loan repayment – especially advantageous for long-term loans like home loans.
If you’re considering a home loan, SMFG Grihashakti offers funds of up to INR 1 crore* to help you purchase your dream property. Apply online today to enjoy competitive interest rates starting from 10%* per annum and flexible loan tenures of up to 30 years*.
*Interest calculations can vary based on factors such as loan amount, tenure, interest rate, repayment schedule, prepayments, and individual lender policies. Always read the terms and conditions carefully and, if necessary, consult with your lender before making a loan decision.