When taking a loan, understanding the interest calculation method is crucial. Two common methods are the Simple Interest (SI) method and the Reducing Balance (RB) method. These methods directly impact how much you end up paying over the loan tenure. It is crucial to pay attention to the borrowing jargons as it helps you understand how you pay up your loans.
Let’s break down the differences and help customers decide which one to choose.
What Is the Simple Interest Method?
Under the Simple Interest method, interest is calculated on the principal loan amount throughout the loan tenure. The formula used is:
SI = (Principal × Rate × Time) / 100
For example, if you borrow Rs 5 lakh at an interest rate of 10% for five years, the total interest is calculated as:
SI = (₹5,00,000 × 10 × 5) / 100 = Rs 2,50,000
The interest amount remains fixed, so your Equated Monthly Instalments (EMIs) are uniform throughout the tenure.
What Is the Reducing Balance Method?
The Reducing Balance method calculates interest on the outstanding loan balance after every EMI payment. As the principal reduces, the interest also decreases over time. The formula here is more dynamic and typically involves:
Interest = Outstanding Balance × Rate × Time (monthly/annually)
For instance, with the same Rs 5 lakh loan at 10% interest over five years, the interest reduces progressively as you pay off the loan. This results in lower total interest payments compared to the Simple Interest method.
Loan Details:
- Loan Amount = ₹5,00,000
- Interest Rate = 10% per annum
- Tenure = 5 years
- EMI = ₹10,624
Repayment Breakdown (First Few Months)
| Month | Loan Balance | Interest Paid | Principal Paid | New Balance |
|---|---|---|---|---|
| 1 | ₹5,00,000 | ₹5,000 | ₹5,624 | ₹4,94,376 |
| 2 | ₹4,94,376 | ₹4,944 | ₹5,680 | ₹4,88,696 |
| 3 | ₹4,88,696 | ₹4,887 | ₹5,737 | ₹4,82,959 |
| … | … | … | … | … |
| 60 | ₹10,500 | ₹87 | ₹10,537 | ₹0 |
Total Repayment Over 5 Years:
Total Interest Paid = ₹1,37,440
Total EMI Paid = ₹6,37,440
With each EMI, the principal reduces, lowering the interest component. Over five years, this method results in lower total interest compared to Simple Interest.
Key Differences Between SI and RB Methods
| Feature | Simple Interest Method | Reducing Balance Method |
| Interest Calculation | Fixed on the original loan amount | Recalculated on the outstanding balance |
| EMI Structure | Uniform throughout the tenure | Decreases slightly over time |
| Total Interest | Higher over the loan tenure | Lower due to reducing principal |
| Transparency | Easier to calculate and understand | Slightly complex but more accurate |
How Do These Methods Impact Customers?
1. Cost of Borrowing: The simple interest method usually results in higher total interest payments. With the Reducing Balance method, you save money as the interest decreases with every payment.”
2. EMI Payments: The Simple Interest (SI) method offers fixed EMIs, which can make budgeting easier. The Reducing Balance (RB) method starts with higher EMIs but gradually reduces, offering relief towards the end of the loan tenure.
3.Loan Transparency: RB is more transparent since you pay interest only on the outstanding balance. SI, though simple to understand, can feel less fair as you continue paying interest on the full loan amount.
Which Method Should You Choose?
The best choice depends on your financial priorities:
- If Cost Matters Most: The Reducing Balance method is more cost-effective in the long run. You save on interest and pay less overall.
2. If Fixed EMIs Are a Priority: The Simple Interest method might be suitable if you prefer predictable monthly payments and don’t mind paying a bit extra over the tenure.
3. Loan Comparisons: Always compare loan offers. Many banks in India advertise their interest rates using the Reducing Balance method, but some may quote Simple Interest rates to appear more competitive.
While the Reducing Balance method is generally more customer-friendly, the Simple Interest method might work for those who prioritise simplicity and fixed payments. Choose wisely based on your financial needs and always compare options before signing the dotted line.
To receive your copy of FREE eBook on Financial Freedom Subscribe Here
This blog is purely for educational purposes. Mutual fund investments are subject to market risks, read all scheme-related documents carefully.
