Reducing Balance Method of Loan Calculation: Online Calculator & Excel Working

Reducing Balance Loan Calculator

Introduction

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 from a perspective of cheap vs costly loans. But first, I’ll tell you the story. Then we will dig deeper into the reducing balance method of loan calculation. It will explain how reducing the balance method makes loans cheaper.

The Story

One day my friend got a call from a bank. He was told that the bank can offer a personal loan @8.5% p.a. interest. My friend was surprised because the normal personal loan rate prevailing at that time was 14%+ per annum. Hence my friend concluded that the call was spammy.

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 confused my friend further, however, he could at least make out that the call was not spammy. Anyway, he disconnected the call and reached me. Together we researched why banks offer two different interest rates on the same loan.

Here are our findings…

Fixed Interest vs Reducing Balance Method

The bank was ready to offer a personal loan @8.5% per annum. When the market rate was 14%, how the bank was offering such low interest rates? The answer was hidden in both the statements of the bank’s executive.

Frequently, when discussing interest rates in the context of home loans, we often refer to the reducing balance method without realizing it. But here 8.5% was offered at the fixed interest method.

• Suggested: Watch this YouTube video.

#1. Fixed interest loan calculation…

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

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 the 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.
• Total Payment: The borrower has to repay the loan principal along with the interest for 1 year. Hence, the total payment due will be Rs.1,08,500 (Rs.1,00,000 + Rs.8,500).
• Monthly Payments (EMI): The borrower has to pay Rs.1,08,500 in equal installments paid each month. Hence, EMI (monthly payments) will be Rs.9,042 (Rs.1,08,500 / 12).

#2. Reducing balance loan calculation

Here we will understand the difference between ‘fixed rate’ and ‘reducing balance rate’. Let’s take the same example as above (in #1), but this time instead of the interest rate being fixed, it will be reducing balance. Suppose one took a loan of Rs.1,00,00 taken @8.5% interest (reducing balance) for 1 year.

This is how the reducing balance loan calculation would look like:

Things to note in the above calculation:

• Monthly EMI: In the reducing balance method, interest calculation is more complicated. Hence, we are using Excel to do the computation. First, we will calculate the EMI using the PMT formula of Excel. Please note the difference in EMI between fixed (Rs.9,042) and reducing balance method (Rs.8,722).
• Lower EMI: In the reducing balance method, the EMI is lower than the fixed interest method. Why? Unlike the fixed interest method, here the interest calculation is done each month. As the loan outstanding reduces each month (after each EMI payment), hence the borrower pays less interest each passing month.

EMI Calculator: Reducing Balance Loan Vs Fixed Interest Loan

Check here the reducing balance loan calculator.

Fixed Interest Loan Calculator

Principal Loan Amount (Rs.)
Interest Rate (%)
Time (in years)

Total Interest (Rs.)
Total Payment (Rs.)
EMI (Rs.)

EMI is less in “reducing the balance method”, Why?

For borrowers, the reducing balance method is economical. How? Because they have to pay less EMI. Why EMI is less? Because of the way the interest calculation is done. To understand this, let’s take the same example as above but here we’ll do a more detailed calculation (of each passing month).

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

Reducing Balance Rate of Interest Calculation in Excel

Check how the interest load gets lowered each month. This happens because the interest calculation is done on the “loan balance” that is available at the end of each month (after each EMI gets paid). As the loan balance is reducing every passing month, interest on the loan is accordingly reducing.

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

Calculation in Excel Using Fixed Interest Method

Check how the interest load remains the same each month. This happens because the interest calculation is done based on the loan balance in the first month. No matter if the loan balance is reduced with EMI’s being paid, 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	Interest is calculated on which loan balance	Complicated	Simple
3	Interest paid each month	Reduces with time	Remains constant with time
4	Based on the loan balance of the first month	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 at the beginning of the blog post. Banks were ready to offer loans to my friend at two 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 banks 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 for us from the above table:

• Reducing Balance Loan: Though the visible interest rate of the “reducing balance loan” looks visually higher, the total payable by the borrower (principal + interest) is small.
• Fixed Interest Loan: Though the visible interest rate of the “fixed interest loan” is small, the total payable by the borrower (principal + interest) is high.

Conclusion

The reducing balance method is a more borrower-friendly approach to interest calculation on loans. Why? Because when we pay EMI each month, there is a simultaneous reduction in loan outstanding balance. When the loan balance reduces, the accrued interest must also fall. The 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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