When you take a loan, your Equated Monthly Instalment (EMI) may look fixed, but the way interest is calculated makes a big difference to the total amount you repay. Under the reducing balance method, interest is charged only on the remaining loan amount after each EMI payment. As your principal reduces over time, the interest portion also decreases.
This means you pay less interest than the flat rate method. In this blog, you will understand how the reducing balance method works, its EMI formula, and how it helps lower your total repayment burden.
The reducing balance method is a way to calculate loan interest on the outstanding loan amount rather than on the original principal. After each EMI payment, a portion of the loan is repaid. The next month’s interest is charged only on the remaining balance. As the loan amount reduces over time, the interest amount decreases as well.
This method lowers the total interest paid over the loan tenure compared to a flat rate interest calculation.
The key difference between the reducing balance method and the flat rate method lies in how interest is calculated. This directly impacts your total repayment and loan cost.
| Feature | Reducing Balance Method | Flat Rate Method |
| How Interest is Calculated | Interest is charged only on the outstanding principal after each EMI. | Interest is charged on the full loan amount for the entire tenure. |
| Interest Over Time | Interest reduces as the loan balance decreases. | Interest remains the same throughout the loan period. |
| EMI Structure | In the beginning, more EMI goes toward interest. Over time, more goes toward principal. | EMI split remains almost constant during the tenure. |
| Total Repayment | Total interest paid is lower over the long term. | It may look cheaper initially, but has a higher effective cost. |
| Cost Efficiency | More cost-effective and borrower-friendly. | It may look cheaper initially, but it has a higher effective cost. |
A proper understanding of the EMI formula is necessary when dealing with reducing balance interest. Here is the formula used for the calculation of EMI under a reducing balance loan:
EMI = [P × R × (1+R) ^N] / [(1+R) ^N – 1]
Where:
P = Principal Amount of Loan
R = Monthly interest rate (annual rate divided by 12*100)
N = Loan tenure in months
In this method, interest is applied only to the outstanding principal each month. The principal amount gets reduced with the payment of loan EMIs. Hence, the interest charged in the next cycle is also reduced. This is why loans calculated on a reducing balance basis are more effective than flat-rate loans.
Here is the EMI Amortisation table for the 1st five instalments of a loan of ₹10 lakhs at a 10% annual interest rate with a tenure of 5 years.
| Month | Outstanding Loan Amount (₹) | EMI (₹) | EMI Amount goes towards Principal (₹) | EMI Amount goes towards Interest (₹) | Loan Amount Closing Balance (₹) |
| 1 | 1000000 | 21247.04 | 12913.71 | 8333.33 | 987086.29 |
| 2 | 987086.29 | 21247.04 | 13021.33 | 8225.72 | 974064.96 |
| 3 | 974064.96 | 21247.04 | 13129.84 | 8117.21 | 960935.13 |
| 4 | 960935.13 | 21247.04 | 13239.25 | 8007.79 | 947695.87 |
| 5 | 947695.87 | 21247.04 | 13349.58 | 7897.47 | 934346.3 |
The above EMI amortisation table clearly shows how the EMI component changes over time. At the start, you can see that a major portion of EMI goes towards interest payments. But as the outstanding balance reduces, the interest amount decreases, and the share of principal in the EMI increases. This shift is the biggest advantage of reducing the balance interest. If you make partial prepayments in earlier years, the principal amount reduces faster, reducing overall interest.
To ensure accurate loan calculations and avoid costly mistakes, follow these simple tips while using an online EMI calculator:
To know the EMI of your loan, use the DMI Finance Personal Loan EMI Calculator and the DMI Finance Business Loan EMI Calculator.
A monthly reducing balance method has several benefits, which are as follows:
Interest Savings Increase Every Month
One of the major benefits of an EMI reducing balance loan is that the interest liability decreases every month. Since interest is calculated on the outstanding principal, each EMI payment reduces the base amount on which the next month’s interest is charged. This gradual monthly reduction leads to significant savings over the loan tenure.
Tenure Shortens Without Extra Cost
Another important benefit is the ability to reduce the loan tenure without increasing the EMI. When you prepay under the reducing balance method, lenders usually adjust the tenure while keeping the EMI unchanged. This allows you to close the loan faster without additional financial burden.
Under the reducing balance method, interest is charged only on the outstanding principal. This helps borrowers reduce their total interest cost over time compared to flat-rate loans. Many lenders, such as DMI Finance, offer personal loans under this structure.
The reducing balance method transforms ordinary EMIs into a powerful savings tool. Since interest is calculated only on the outstanding principal, every payment reduces your future interest burden. Over time, this structure helps lower the total cost of borrowing.
Choosing the right lender from the beginning and making timely repayments, especially in the early years, can help you save significantly across the loan tenure. With DMI Finance, you can access personal loans on the reducing balance method, benefit from competitive rates, and manage your loan easily through a fully digital process. Click here to apply.
1. What is the reducing balance method in simple terms?
The reducing balance method is one in which the interest is charged only on the current loan balance and not the original amount. As a result, the interest decreases each month as the principal is repaid.
2. Does the reducing balance method lower my EMI?
Under this method, the EMI amount remains fixed, but the interest keeps on shrinking.
3. Flat rate vs reducing balance method: which saves more?
The reducing balance method can save 25%-35% of total interest compared to flat rate loans, which may appear to offer lower rates but actually cost more overall.
4. Can I prepay on reducing balance loans?
Yes, you can prepay on reducing balance loans, depending on the lender’s policy, which instantly reduces future interest on the remaining balance. As a result, tenure is shortened without any penalties.
5. How to calculate reducing balance interest manually?
You can use the EMI formula with outstanding principal to manually calculate the reducing balance interest. You can also use various online tools that show the month-wise interest principal split.
6. Is the reducing balance method standard for personal loans?
The majority of lenders use the reducing balance method in personal loans. However, you can confirm it from the lender itself before signing the agreement to avoid a flat rate.
7. Is the reducing balance method better for long-term loans?
Yes, it is usually better for long-term loans because the interest keeps reducing as you repay the principal. Over a longer period, this can lead to significant savings.
8. Does my credit score affect the interest rate under this method?
Yes, your credit score plays an important role. A higher credit score can help you get a lower interest rate, which further reduces your total repayment.
9. Can the interest rate change during the loan tenure?
If you choose a fixed interest rate, it remains the same. If you choose a floating rate, it may change based on market conditions.
10. Is the reducing balance method used for home loans, too?
Yes, most home loans are calculated using the reducing balance method, which helps borrowers save on total interest over the loan tenure.
