What Is the Monthly reducing balance method in Loans?

Summary

If you’ve taken a loan or are planning to apply for one, you might come across terms like flat rate or reducing balance method. Among these, the monthly reducing balance method is one of the most widely used by banks and NBFCs for home loans, personal loans, and business loans. But what does it mean? How does it affect your EMI and interest payments? In this blog, we break it down in simple terms to help you understand how this method works and why it might save you money in the long run.

Key Takeaways

• Monthly reducing balance method calculates interest on the remaining loan amount every month
• This method lowers your interest payout over time
• It’s different from flat rate loans where interest is charged on the full amount
• Most home and personal loans in India follow this method
• Knowing how it works helps you compare loans better and choose smartly

Table of Contents

1. What Is the Monthly Reducing Balance Method?
2. How It Works in Simple Terms
3. Monthly Reducing vs Flat Interest Rate: What’s the Difference?
4. Why Most Banks Use the Reducing Method
5. EMI Calculation: An Example
6. Benefits of Monthly Reducing Balance
7. Things to Watch Out For
8. Final Thoughts
9. FAQs

1. What Is the Monthly Reducing Balance Method?

In this method, interest is calculated only on the outstanding loan amount at the end of each month — not on the original amount borrowed.

• Every month, as you pay your EMI, part goes to interest, rest to principal
• As principal reduces, next month’s interest is calculated on a lower amount

It’s called “reducing balance” because the loan balance on which interest is charged keeps reducing every month.

2. How It Works in Simple Terms

Let’s say:

• Loan: ₹5 lakh
• Interest rate: 12% per annum
• Tenure: 3 years

In the first month, interest is charged on ₹5 lakh. After your first EMI, the principal comes down slightly. In the second month, interest is calculated on the reduced balance, and so on.

This makes your interest payout lower over time, unlike the flat rate method where interest is charged on ₹5 lakh throughout.

3. Monthly Reducing vs Flat Interest Rate: What’s the Difference?

4. Why Most Banks Use the Reducing Method

• Banks and NBFCs prefer the monthly reducing method because:

  • It is more transparent for borrowers
  • Encourages faster repayment
  • Aligns with RBI guidelines for fair interest calculation
  • Works better with longer-tenure loans like home loans

  That’s why most housing loans, personal loans, and business loans in India follow this method.

5. EMI Calculation: An Example

Let’s compare EMI using both methods.

Loan Details:

• Loan Amount: ₹5,00,000
• Interest Rate: 12%
• Tenure: 3 years

A. Flat Rate Method

• Interest = ₹5,00,000 × 12% × 3 = ₹1,80,000
• Total repayment = ₹6,80,000
• EMI = ₹18,889

B. Monthly Reducing Method

• EMI = approx. ₹16,607
• Total repayment = approx. ₹5,97,852
• Interest = approx. ₹97,852

Savings = ₹82,148

That’s a big difference.

6. Benefits of Monthly Reducing Balance

• Lower overall interest: You pay less over the loan period
• Better for long-term loans: Especially home or business loans
• Transparency: You can clearly see how interest reduces every month
• Faster principal repayment: Encourages better financial discipline
• Option for prepayment: You save even more if you pay off early

7. Things to Watch Out For

• Don’t confuse reducing balance with floating rate: Reducing balance refers to the method of interest calculation, not whether the rate is fixed or floating
• Ask for amortization schedule: This shows how your EMI is split each month between interest and principal
• Check effective rate: A 10% flat rate may sound cheaper than a 12% reducing rate — but the reducing method will usually cost less overall
• Compare APR: Some lenders may not disclose total cost upfront. Always ask for the annual percentage rate (APR)

8. Final Thoughts

Understanding the monthly reducing balance method helps you become a smarter borrower. Many people just look at the interest rate number — but how it’s calculated matters even more. This method helps you save money as your loan progresses, especially in longer-term loans. The next time you're comparing two loan offers, look beyond the headline rate and ask the lender about their interest calculation method.

9. FAQs

Q1. What is the monthly reducing balance method?
It’s a way of calculating loan interest on the remaining loan amount each month, instead of the original loan amount.

Q2. Is monthly reducing balance better than flat rate?
Yes, it usually results in lower total interest payments over the loan period.

Q3. Do all banks follow this method?
Most banks and NBFCs use this method for home, personal, and business loans. Flat rate is more common in short-term or consumer loans.

Q4. How does it impact my EMI?
Your EMI remains the same, but more of it goes towards principal over time, reducing interest.

Q5. Can I get a schedule showing the reducing balance?
Yes, ask your lender for an amortization table. It shows monthly breakup of principal and interest.

Q6. Does it apply to both fixed and floating rate loans?
Yes. Reducing balance is about how interest is calculated, not whether the rate itself changes.

Q7. How can I save more using this method?
Make occasional part-prepayments to reduce principal — your future interest and EMIs will reduce further.