With the escalating real estate prices and otherwise also, home loans have been helping a large number of people in India achieve their one of the biggest goals in life as they help arrange adequate funding for buying a residential real estate. In fact, there are many options for borrowers specifically meant to individual needs that lenders offer these days.
However, if you’re planning to take a housing loan to acquire your dream home, it’s 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?
Reducing-balance loans
Most financial institutions offer reducing balance loans for housing. Under this method, interest is computed based on the outstanding principal amount following each repayment. With each EMI payment, the outstanding loan balance diminishes.
Therefore, if you’re paying monthly EMIs on your housing loan, the lender will calculate interest after each payment based on the reduced outstanding amount. This explains why the interest component is the highest at the beginning of a repayment cycle. As the outstanding principal reduces with each payment, the interest component in the EMI also decreases.
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. The interest for each month is calculated based on the reduced outstanding principal amount after the last EMI payment. This means that as you continue to make payments, the interest component decreases, while the principal component of your EMI increases over time.”
How is this method applied?
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, 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, 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 continues throughout the tenure.
How can this strategy help?
In the fixed-rate method, interest is computed on the entire loan amount. Unlike the reducing balance method, the principal amount remains unadjusted after repayments. Consequently, you will pay the same interest amount every month throughout the loan tenure.
The reducing balance loan formula calculates interest based on the outstanding balance rather than the entire loan amount. Consequently, the total interest expenditure on your home loan repayments is lower in reducing balance loans compared to fixed-rate loans.
Shetty says, “The reducing balance method is the most common way of calculating interest, and is used for most types of loans including personal loans, home loans and car loans. It helps borrowers reduce theiroverall interest burden, as interest component of the EMI reduces over time.”
Interest savings
This method can significantly help you save interest repayments. You must get more clarity about this strategy at the time of applying for a housing loan. It is also important to read the terms and conditions and any applicability of this rule in individual cases to avoid confusion.
You must focus on getting more knowledge about housing loans and their repayment to avert potential discrepancies in the future.
One of the most important things before you deploy any strategy to minimise your interest burden, you must make timely repayment of your loan without any delay and defaults. This will help you maximise the benefits of interest calculation when you apply any method to reduce your home loan interest outflow.
LIGHTER BURDEN
- Reducing-balance method is used for home loans, personal loans & car loans
- Total interest outgo is lower in such loans compared to that in fixed-rate loans
- The interest component is the highest at the beginning of a repayment cycle