Loans have been one of the most useful financial instruments and the basis for the creation of Banks. Loans enable people to purchase things for which they do not possess money at the moment. A loan is a guarantee by the bank to the seller. Normally during the purchase of homes, cars, two-wheelers, or any other assets, Banks pay the entire amount to the seller in one go, and avail the same amount from the customer with interest over the course of months or years.

Equal Monthly Instalments or EMIs emerged as a convenient option of payment for cars, vehicles, electronics and other essentials which allowed customers to pay for the required item in equal parts, with interest. Banks also offer to provide a reducing balance compound interest rate while setting personal loan interest rates. Every financial institution has a different method of calculating EMIs. Two of the prominent methods for the calculation of EMI are fixed rate of interest calculation and second is the compound interest basis which is calculated on the basis of reducing balance.

Reducing Balance Method

Reducing Balance Interest Method of loan interest payment has been prominent due to the benefit it provides to the customers of paying less that the fixed interest rate. With Reduced balance method, the interest decreases as the principal payment amount decreases. Accordingly, the rate of interest for monthly reducing balance seems high, but equals to a lower fixed interest rate. For instance, if you have purchased a vehicle worth INR 1,00,000 and aim to pay the loan by 3 years with a reducing balance interest rate of 17.92%, the total interest paid will be INR 30,000, which is the same as 10% fixed interest on the same.

If you want to calculate monthly reducing interest on EMI payments, take the principal amount remaining on the first month, calculate the interest on this amount, which is the amount payable for the first month. In the next month, interest rate will be the same, but with a reduced principal amount, the EMI value will decrease. However, to easily calculate the EMI amount for a reducing balance, the easier option is to convert the rate of interest from monthly reducing to the equivalent fixed interest rate (for instance, 9% fixed interest rate equals to 16.24% reducing balance). If you are still facing confusion in doing so, you can use this EMI calculator which allows you to easily calculate the EMI for monthly reducing balance and to convert it into the equivalent fixed interest rate as well.

Calculation of EMIs helps in saving and budgeting accordingly, which encourages savings and instils convenience of payments on a regular basis for purchasing homes and cars, and also helps in understanding personal loan interest rates.