Five minutes to understanding reducing balance

What is a ‘reducing balance’ loan?Suppose you took a Rs 1 lakh loan today at a rate of interest of 10 per cent for five years. You...

What is a ‘reducing balance’ loan?
Suppose you took a Rs 1 lakh loan today at a rate of interest of 10 per cent for five years. You are to pay back Rs 20,000 of the principal and Rs 10,000 (10 per cent of the loan) every year. So you pay back Rs 30,000 every year. Over five years you pay back Rs 1.5 lakh. But notice, that the loan kept reducing over the five years as you paid back Rs 20,000 each year, yet you went on paying interest for five years, as if you had kept the Rs 1 lakh for the entire term.

What if you paid an interest only on the amount you owed each year and not the entire one lakh?
The first year you would pay Rs 10,000 as interest, the next year you would pay Rs 8,000 on a reduced principal of Rs 80,000 and so on, till the last year, you pay only Rs 2,000 as interest. Now you would have paid back Rs 1.3 lakh instead of Rs 1.5 lakh as in the earlier case.

The first case is a situation of a loan that charges interest at a flat rate and the second case is when the interest is calculated on a ‘reducing balance’ or only on the amount of loan left to pay and not the entire loan amount. A flat 10 per cent is equal to a reducing balance at 6 per cent per annum.

How often can the balance reduce?
You can get a range of options in reducing balance loans. You get annual, quarterly, monthly, weekly and now daily rests. A ‘rest’ is jargon to indicate when the bank will recalculate the EMI based on the amount of loan paid back. Suppose you have a loan with an annual ‘rest’ then, though you pay a monthly instalment, your benefit kicks in only at year end. Meaning the bank gets free interest for 11 months. A monthly ‘rest’ will recognise the reduction in the loan amount on a monthly basis and a daily ‘rest’ will do it each day.

What use is a daily ‘rest’ if the EMI is monthly?
True, the loan instalments are usually on a monthly basis but new innovative products in the market make daily rests a possibility. For example, some home loan companies give an option to park extra funds in an account linked to the home loan account. The interest on the home loan is calculated keeping in mind the number of days the extra cash stays in that account and reducing the principal for those many days by the amount in the bank. A non-reducing balance loan is out of question today, settle for a monthly rest if you pay back each month or if there are options of continuous pre-payment of the loan, then ask for a daily rest.

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