The Reducing Balance Method For Home Loans
Priyanka Singh, a 32-year-old-human resource manager in a multinational, has been window-shopping for the best home loan deal. After a long search, she signed on the dotted line, because she found the best possible deal under the prevailing lending conditions. Nevertheless, she did not notice a clause which mentioned that the home loan interest rate will be calculated according to a flat interest rate. Priyanka did not know what that meant.
We do not want you to get into something you do not fully understand.
MakaanIQ tells you more about the reducing balance method for home loans, when buying an apartment in India and why it may serve your interests better.
What is the 'Reducing Balance Method'?
Home loan equated monthly instalments (EMIs) are usually calculated on a reducing balance method. As the title suggests, under this method, the balance of home loan declines as you pay off your debt. In other words, the interest on a home loan is calculated and charged every month, but only on the outstanding balance of loan. The principal portion of the EMI declines and the interest is calculated on the remaining amount, every month.
The rationale is obvious. Why would you want to pay interest on principal amount if you have partially paid it off?
The principal amount component of the EMI lowers the loan balance, while the interest payment you make is the cost of borrowing from the bank. It is important to note that the principal amount component you need to pay will remain the same, but the interest component will become smaller and smaller till it becomes as low as possible at the end of the loan tenure.
In Priyanka's case, she will be expected to pay the same amount of interest during the entire course of the home loan tenure (i.e. under a flat interest rate). She will not benefit from the interest rate being calculated on the reduced or outstanding amount of the loan. The payment she makes toward the principal amount will not have any impact on the interest component. She will have to pay interest on the initial principal amount.
How does the reducing balance method work?
The reducing balance method depends on the frequency at which the outstanding principal is paid and reworked. Payments are made daily, monthly, quarterly or annually. Let us suppose you pay your EMI on the 10th of every month. Now, if your outstanding balance on the home loan is calculated on the 11th of the month, the frequency of reworking the interest on the outstanding principle will be daily. Similarly, the frequency of reworking the interest on the outstanding principle can be monthly, quarterly or annually.
What makes the daily frequency of reducing balance method better?
The daily reducing balance method is always better, when compared to the balance declining every month, if you are paying some amount above your monthly payments (i.e. part payment). This is so, because the outstanding balance of the loan/principal amount declining the day after the additional payment, instead of declining a month since then, will ultimately lead to lower interest payment.
The underlying concept is that the annualised rate is calculated based on the number days in a year, which is 365. If the loan or the principal amount declines every month, the number of days in a year would be, in effect, 360 (12 months*30 days). So, the interest payment you make will be a little higher when the principal component declines every month, when compared to it declining every day.
Do not go for the home loan that offers the lowest possible interest rate while choosing your home loan. You should also find out how the interest rate is calculated. There may be downsides to home loans with the lowest interest rates.