COMPUTING THE COST OF YOUR LOAN: Reducing-balance loan minimises interest outgo

financialexpress.com:

If you are planning to take a housing loan to acquire your dream home, it is prudent to acquaint yourself with as much information about the loan as possible. Interest constitutes a substantial portion of the total repayment made by a borrower to the lender over the loan’s duration. Lenders employ the monthly reducing balance method for interest calculation on home loans.

So, what is this method, and how is it employed?

Most financial institutions offer reducing-balance loans for housing. Under this method, interest is computed based on the outstanding principal following each repayment. Adhil Shetty, CEO, Bankbazaar.com, explains, “With the monthly reducing-balance method, the interest on the outstanding loan balance is calculated monthly.

After each EMI payment, the outstanding principal balance decreases. This means that as you continue to make payments, the interest component decreases, while the principal component of your EMI increases over time.”

This explains why the interest component is the highest at the beginning of a repayment cycle.

Let us see how this method is applied. Suppose a home buyer has taken a loan of Rs 50 lakh at 8% interest for 20 years. The EMI amount would be Rs 41,822, comprising a principal component and an interest component. In the first month, i Interest is applied to the entire outstanding amount of Rs 50 lakh. Consequently, the interest component in the EMI of Rs 41,822 will be Rs 33,333, while the principal component will be8,488. In the second month, month, interest is applicable to Rs 49,58,178 (total outstanding minus EMI paid). While the EMI remains the same (Rs 41,822), the interest component decreases to 33,276, and the principal component goes up to Rs 8,545. This cycle