The loan type in which the framework works on the basis of the outstanding amount decreasing is called the reducing balance loan. It is also called rest in the banking jargon.
It defines the time period after which the bank reduces the principal amount as the borrower pays the installments. The installments are paid every month.
The frequency of this balance reduction on a loan affects the cost of borrowing. The EMI, that is the equated monthly installment, is calculated while the outstanding principal is cleared and the interest is further charged on the outstanding amount.
To charge the interest on the remaining amount, different loan providers adopt different time periods of charging.
Theoretically, there are four types of rest basis which the outstanding amount is reduced. These are daily, monthly, quarterly and annual. However, the quarterly reducing balance is not in use. The rest three reducing balance types are the most prominent, the monthly reducing balance type being the most common of all.
The difference might not seem to be substantial, however, the results and the EMIs to be paid to turn out to have skewed differences. Let us discuss all one by one.
In all the three kinds of reducing balance or rest types, the formula to calculate the Equated monthly installments remains the same.
Annual Reducing Balance
In an annual reducing balance, the rate of interest is calculated on the reduced principal. However, it is charged at the end of the year and the whole year the borrower pays the interest on the outstanding which is fixed and is not reducing.
The equated monthly installments, the EMIs, are paid every month. These loans are less prominent that the loans with monthly reducing balance. The loan interest is computed based on the previous year’s outstanding balance.
Monthly Reducing Balance
The monthly reducing balance is the one where the outstanding balance is updated every month. In the monthly reducing balance, the principal amount keeps reducing every month as the EMIs are waived every month. The monthly reducing loan cycle type is the most common cycle type. Monthly Reducing Cycle is mainly used in the home, vehicle, business and personal loans.
Daily Reducing Balance
Other than the monthly reducing balance type and the annual reducing balance type, there is yet another type of loan called the daily reducing balance. In this reducing balance cycle, every day the new outstanding balance is calculated on the basis of the present loan amount after the equated monthly installment is paid. This is beneficial when you want to prepay the loan.
In this loan calculation cycle, since the outstanding amount reduces with every passing day, the EMIs should also be updated and paid on the daily basis. In this case, the equated monthly installment (EMI) should turn into the equated daily installment or EDI.
However, this is very unpractical. No one can go to the bank every day or even pay installments daily via an online method or cheque method. This is because it is very difficult to track and will just load the system and the bank or finance companies’ employees. Hence, the payments are made on the monthly basis but the outstanding amount is calculated in such a way as if the EMIs were paid daily.
Now, the bigger and the most important question is that which interest cycle should you choose for your upcoming loan?
Well, if you have the option of choosing from the three types of loans, you should go with the daily reducing balance cycle loan. This is because, in this loan type, the benefit is inclined towards the borrower. This goes down to the fact that in daily reducing balance, the outstanding balance reduces every day, and so the interest charged also reduces. This means the borrower will have to pay the least amount.
When comparing the monthly reducing cycle and the annual reducing cycle, the former is more beneficial. This is because, in the latter, the outstanding amount does not change which means that the interest charged will remain the same even after paying the EMIs every month.
To conclude, it can be said that the monthly reducing balance is more advantageous to the borrower than the annual reducing balance. The daily reducing balance cycle is the most beneficial of all. In the longer run and for more amounts, the annual reducing balance costs almost the double the daily reducing balance.
However, in most of the cases, it is the monthly reducing balance cycle that is incorporated in the system by the lenders. So, the borrowers are not really left with much of the option. Yet, if possible, the daily reducing balance cycle works great in reducing the loan.
So, which cycle would you choose?