Reducing Balance

Full form: Diminishing Balance Method

Loans & Credit

Reducing balance (also called diminishing balance) is the loan interest calculation method where interest is charged only on the outstanding principal, not the original loan amount. All RBI-regulated bank loans use this method. It is more borrower-friendly than the flat rate method.

In detail

In the reducing balance method, each EMI first pays the interest on the current outstanding balance. The remaining amount reduces the principal. The next month's interest is on the reduced balance. This creates an accelerating principal repayment effect.

Key difference from flat rate: on a Rs 1L loan at 10% for 3 years -- flat rate: total interest = Rs 30,000. Reducing balance: total interest = Rs 16,162 -- almost half. Yet many lenders quote flat rates making their loans appear cheaper.

Formula

Monthly interest = Outstanding balance x (Annual rate / 12 / 100) Principal paid = EMI - Monthly interest New balance = Old balance - Principal paid Month 1: Entire principal outstanding Month n: [P x (1+r)^n - P x (1+r)^n + P] / ... reduces progressively

Real-life example

🇮🇳 India example

Rs 5L car loan at 10% reducing balance for 3 years. EMI = Rs 16,134. Month 1: interest = Rs 4,167, principal = Rs 11,967. Month 36: interest = Rs 133, principal = Rs 16,001. Total interest = Rs 80,826. Same loan at 10% flat rate would be quoted as Rs 1.5L total interest -- dealer is hiding that the effective reducing rate is 18.7%.

Frequently asked questions

Why do dealer loans quote flat rates instead of reducing balance? ▼
Because flat rates appear lower. A 10% flat rate sounds cheaper than a 12% reducing balance rate -- but 10% flat equals approximately 18.7% reducing balance for a 3-year loan. RBI mandates that all loans disclose the Annual Percentage Rate (APR) -- always ask for APR before signing.