While browsing for various home loan products, you would have come across terms, Monthly Reducing Balance and Daily Reducing Balance. Home loan products from many banks including State Bank of India work on daily reducing balance method while the home loan products from some banks work on monthly reducing balance methods.
What Is the Difference?
The difference lies in the way interest is calculated. Technically, in a daily reducing method, the interest is calculated on the outstanding principal on a daily basis. i.e., for the purpose of calculating interest for the month, the average daily outstanding principal amount is considered.
In monthly reducing method, balance at the end of previous month is considered for interest calculation. For more on reducing balance method loans, suggest you go through this post. Clearly, from the perspective of the borrower, daily reducing balance is better.
However, since you pay EMIs (equated monthly instalments) and not equated daily instalments, there is no real difference between the two methods so far as you are concerned. In such a case, previous month ending balance and daily average balance for the month will remain the same. The difference will come if you made a pre-payment.
Let’s consider an example. Suppose your EMI is due 1st of every month. Let’s assume you have taken a loan at 10% p.a. After the payment of your last EMI, let’s assume your outstanding principal balance is Rs 10 lacs. Suppose you make a pre-payment of Rs 5 lacs on 7th of the month.
- In case of monthly reducing balance method, Rs 10 lacs (outstanding at the end of last month) will be used to calculate interest for the month. Interest for the month will be Rs 10 lacs * 10%/12 = Rs 8,333
- In case of daily reducing balance, the calculation will be done as follows: (7 * Rs 10 lacs + 23 * Rs 5 lacs)/30 = Rs 6.17 lacs (monthly average outstanding). Interest for the month = Rs 6.17 lacs * 10%/12 = Rs 5,138
How Does This Affect You?
EMI is same in both the cases. Since the interest for the month is lesser in the daily reducing method, a greater portion of that EMI will go towards settling the principal. Effectively, after the payment of next EMI, you will have Rs 3,195 of lesser principal outstanding.
Again, how it affects you? Let’s suppose, after last month’s payment, Rs 10 lacs was outstanding for 5 years. EMI was Rs 21,247. After pre-payment of Rs 5 lacs, as mentioned above, the loan gets repaid in 27 months.
Monthly Reducing Balance
| Outstanding at the beginning of the month | EMI | Interest Payment | Principal Repayment | Prepayment | Outstanding at the end of the month | |
| 1 | 10,00,000 | 21,247 | 8,333 | 12,914 | 5,00,000 | 4,87,086 |
| 2 | 4,87,086 | 21,247 | 4,059 | 17,188 | – | 4,69,898 |
| 3 | 4,69,898 | 21,247 | 3,916 | 17,331 | – | 4,52,567 |
| 4 | 4,52,567 | 21,247 | 3,771 | 17,476 | – | 4,35,091 |
| 5 | 4,35,091 | 21,247 | 3,626 | 17,621 | – | 4,17,470 |
| 6 | 4,17,470 | 21,247 | 3,479 | 17,768 | – | 3,99,702 |
| 7 | 3,99,702 | 21,247 | 3,331 | 17,916 | – | 3,81,786 |
Daily Reducing Balance
| Outstanding at the beginning of the month | EMI | Interest Payment | Principal Repayment | Prepayment | Outstanding at the end of the month | |
| 1 | 10,00,000 | 21,247 | 5,139 | 16,108 | 5,00,000 | 4,83,892 |
| 2 | 4,83,892 | 21,247 | 4,032 | 17,215 | – | 4,66,677 |
| 3 | 4,66,677 | 21,247 | 3,889 | 17,358 | – | 4,49,319 |
| 4 | 4,49,319 | 21,247 | 3,744 | 17,503 | – | 4,31,816 |
| 5 | 4,31,816 | 21,247 | 3,598 | 17,649 | – | 4,14,168 |
| 6 | 4,14,168 | 21,247 | 3,451 | 17,796 | – | 3,96,372 |
| 7 | 3,96,372 | 21,247 | 3,303 | 17,944 | – | 3,78,428 |
So, you can see the lesser interest payment for one month has some continued effect on the repayment. As it works in reducing balance method loans, as the principal goes down, the repayment automatically gets expedited. In this case, you will save about Rs 4,000 over the course of the loan.
Frankly, not much to worry about. In my opinion, this topic is more for academic interest than anything else. I wouldn’t base my decision on the reset period of the loan especially since the EMI is monthly.
Well, There Is Annual Reducing Balance Loan Too
A loan is a contract and can be worded in any manner. Now, the reset frequency could be annual too. Now, here you have a problem. In annual reducing balance, outstanding balance for the previous year shall be considered for calculation of interest on a monthly basis.
For instance, in case of Rs 10 lac loan for 10 years at 10% p.a., you will pay a monthly EMI of Rs 13,215 under monthly reducing balance method.
Annual Reducing Balance
| Outstanding at the beginning of the month | EMI | Interest Payment | Principal Repayment | Prepayment | Outstanding at the end of the month | |
| 1 | 10,00,000 | 13,562 | 8,333 | 5,229 | – | 9,94,771 |
| 2 | 9,94,771 | 13,562 | 8,333 | 5,229 | – | 9,89,542 |
| 3 | 9,89,542 | 13,562 | 8,333 | 5,229 | – | 9,84,314 |
| 4 | 9,84,314 | 13,562 | 8,333 | 5,229 | – | 9,79,085 |
| 5 | 9,79,085 | 13,562 | 8,333 | 5,229 | – | 9,73,856 |
| 6 | 9,73,856 | 13,562 | 8,333 | 5,229 | – | 9,68,627 |
| 7 | 9,68,627 | 13,562 | 8,333 | 5,229 | – | 9,63,399 |
| 8 | 9,63,399 | 13,562 | 8,333 | 5,229 | – | 9,58,170 |
| 9 | 9,58,170 | 13,562 | 8,333 | 5,229 | – | 9,52,941 |
| 10 | 9,52,941 | 13,562 | 8,333 | 5,229 | – | 9,47,712 |
| 11 | 9,47,712 | 13,562 | 8,333 | 5,229 | – | 9,42,483 |
| 12 | 9,42,483 | 13,562 | 8,333 | 5,229 | – | 9,37,255 |
| 13 | 9,37,255 | 13,562 | 7,810 | 5,752 | – | 9,31,503 |
| 14 | 9,31,503 | 13,562 | 7,810 | 5,752 | – | 9,25,751 |
| 15 | 9,25,751 | 13,562 | 7,810 | 5,752 | – | 9,20,000 |
| 16 | 9,20,000 | 13,562 | 7,810 | 5,752 | – | 9,14,248 |
| 17 | 9,14,248 | 13,562 | 7,810 | 5,752 | – | 9,08,496 |
| 18 | 9,08,496 | 13,562 | 7,810 | 5,752 | – | 9,02,745 |
You can see how interest portion remains constant for a year. Under Annual reducing balance, you will pay an EMI of Rs 13,562. That’s a difference of Rs 347 per month. Over the loan term of 10 years, this will translate into an absolute difference of Rs 41,645. Now, this difference is significant. The difference will be bigger if the loan amount is bigger. For the loan under question, interest rate of 10% p.a. under Annual reducing balance method is equivalent of 10.62% p.a. under monthly reducing balance method. Therefore, this can be a very clever way of offering a high rate product under the guise of a relatively low interest rate.
An additional point to note is that, between daily and monthly reducing balance loans, the difference would come only if you prepay the loan. Between monthly and annual reducing balance, the difference will always be there. It is not contingent upon pre-payment of loan. Between daily and monthly reducing balance loans, the interest is only academic since the loan is being repaid through monthly payments in both the cases. It is always good to understand how calculations work though. And most loans are either daily or monthly reducing. However, do appreciate the actual cost if you find “Annual reducing balance” mentioned in your loan document or product brochure. Things may not be as rosy as they appear.