Many borrowers don’t realise how interest is calculated, and that's why I always come across people searching for how to reduce their balance using a specific loan calculator. But to be sincere, there's the reality because flat-rate loans can look cheaper but aren’t; a reducing balance loan calculator shows the real picture.
In this article, I'm going to walk you through everything you need to know about the loan calculator for reducing balance, the EMI formula, an example and the breakdown step by step. But first, let's start with the question: what is a reducing balance loan?
A reducing balance loan (also called a diminishing balance loan) is a type of loan where interest is calculated only on the remaining outstanding principal, not on the original loan amount. This simply means if you repay your outstanding loan without default, the interest portion on the loan gets smaller because it’s charged on a shrinking balance.
In this concept, an important phenomenon you should know is the Equated Monthly Instalment (EMI). This is the fixed amount you pay every month to repay a loan. It’s called “equated” because the payment amount stays the same throughout the loan tenure (assuming a fixed interest rate). So, in a reducing balance loan, it works in the sense that each EMI you pay has two parts:
- Principal repayment
- Interest on the remaining balance
Since interest is calculated on the remaining balance, and that balance keeps getting smaller, the interest portion of your EMI gradually reduces. Over time, less of your payment goes toward interest and more of it goes toward actually repaying the principal, which helps you clear the loan faster toward the end. For example, if you borrow $10,000 at 10%, interest in month one is calculated on $10,000. In month two, it's calculated on the remaining balance, not the original amount.
What is a loan calculator on a reducing balance?
A reducing balance loan calculator is a simple financial tool that helps you figure out exactly what your loan will cost you when interest is calculated on the remaining balance. And I must tell you that this calculator is an incredibly useful tool you must use before you commit to a loan because it'll typically show you the fixed monthly payment (EMI) you’ll need to make based on your loan amount, interest rate, and tenure.
Of course, if you know your EMI before the loan is taken, you'll be able to answer the question "Can I afford this every month?” within yourself. In addition to that, the calculator also calculates how much interest you’ll pay over the entire loan period. If you choose a shorter tenure, you'll make prepayments because the number decreases.
Total EMI paid over tenure = Principal + Total Interest
It's also worth noting that some calculators go a step further and give you a month-by-month breakdown, including the EMI amount, interest component, principal component, and the remaining loan balance. I must commend that these types of calculators will let you see how your loan balance reduces over time and how much interest you save with early repayment.
Meanwhile, you'll need to input the loan amount you want to borrow, the annual interest rate that'll be charged by the lender, and the repayment period to use a loan calculator on a reducing balance. Note that some calculators might require you to input the interest rate and repayment in months, and some might require them per annum.
So, it's left to you to know how the required inputs will be inputted in the calculator for accuracy.
Benefits of a loan calculator on a reducing balance
A reducing balance loan calculator helps you compare loan offers from different lenders. It also helps you to adjust tenure to see how EMI changes. Using the calculator will also let you understand the real cost of borrowing and plan your monthly budget confidently.
In addition to all that, a reducing balance loan calculator helps borrowers to avoid hidden costs that loan sharks often place on their loans and supports smarter prepayment decisions.
It's highly recommended to use a reducing balance loan calculator before taking a home loan and when comparing personal loan offers, planning early loan closure, and checking refinancing options. In a nutshell, a loan calculator on a reducing balance removes guesswork and gives you clarity before you sign anything.
EMI Formula
I purposely include this EMI formula for people who want to calculate their loan manually or people that don't have access to the reducing balance loan calculator.
EMI = (P × r × (1 + r)n) / ((1 + r)n − 1)
Where;
- P (Principal) is the total loan amount you borrowed.
- r (monthly interest rate) is the yearly interest rate divided by 12 (and converted into decimal form). For example, 12% per year becomes 0.01 per month.
- n (Number of months) is how long you’ll take to repay the loan, measured in months (for example, 5 years = 60 months).
