When taking out a loan or applying for a credit card, one of the most important factors is how interest will be calculated. Lenders use several methods to calculate interest, including flat rates and reducing balances. In this article, we’ll focus on the monthly reducing balance method and everything you need to know about it.
What is the Monthly Reducing Balance Method?
The monthly reducing balance method calculates interest on home loans, personal loans or credit card balances based on the outstanding balance at the end of each month. Under this method, interest is charged on the principal amount outstanding at the end of each month, which reduces the principal balance for the following month. This means that as you make repayments on your loan or credit card, your interest charges decrease.
How Does it Work?
Let’s say you have a loan with a principal amount of Rs. 1,00,000, an interest rate of 10%, and a loan tenure of 12 months. Under the monthly reducing balance method, your interest charges will be calculated as follows:
For the first month, your interest charges will be 10% of Rs. 1,00,000, which is Rs. 10,000. Your monthly repayment will be Rs. 8,792, which includes the interest charges and a portion of the principal amount.
At the end of the first month, your outstanding balance will be Rs. 91,208 (Rs. 1,00,000 – Rs. 8,792).
For the second month, your interest charges will be 10% of Rs. 91,208, which is Rs. 9,121. Your monthly repayment will be Rs. 8,792, which includes the interest charges and a portion of the principal amount.
This process will continue for ten months until the loan is fully repaid.
Advantages of the Monthly Reducing Balance Method
There are several advantages to using the monthly reducing balance method to calculate interest on your loans or credit cards. Some of these advantages include the following:
- Lower interest charges
- Faster loan repayment
Disadvantages of the Monthly Reducing Balance Method
While there are several advantages to using the monthly reducing balance method, there are also some disadvantages to consider. These include:
- Higher monthly payments
- Early repayment penalties
- Complex calculations
Calculating Interest on Credit Cards
The monthly reducing balance method is also commonly used to calculate interest charges on credit cards. Credit card companies will typically offer an interest-free period of up to 45 days on purchases, after which interest will accrue. The interest rate charged will depend on the credit card company but will usually be 18-24% per annum.
Under the monthly reducing balance method, interest charges are calculated on the outstanding balance at the end of each billing cycle. You can avoid paying any interest charges if you pay your credit card balance in full each month. However, if you carry a balance from one month to the next, you will start to accrue interest charges on that balance.
To Calculate Your Interest Charges on a Credit Card, You Can Use the Following Formula:
Interest charged = (Outstanding balance x Interest rate x Number of days) / (365 days)
For example, if you have an outstanding balance of Rs. 10,000 on your credit card, an interest rate of 18% per annum, and a billing cycle of 30 days, your interest charges for that billing cycle would be:
Interest charged = (10,000 x 18% x 30) / 365 = Rs. 147.95
You may encounter the term “DSA Partner” when taking out a loan. DSA stands for Direct Selling Agent, and a DSA Partner is a third-party agent who works with banks and financial institutions to offer customers loans and other financial products. DSA Partners are typically paid a commission for each successful loan application and may provide customers with additional services such as loan advice and assistance with paperwork.
If you are considering taking out a loan, choosing a reputable DSA Partner authorized to work with the bank or financial institution in question is important. You can check the credentials of a DSA Partner by verifying their license and registration with the appropriate authorities.
The monthly reducing balance method is a cost-effective and transparent way of calculating interest on loans and credit cards. By charging interest only on the outstanding balance at the end of each month, borrowers can reduce their interest charges and pay off their loans faster.