Q. Banks and lending institutions often advertise different balance reduction periods on their loans. How does the frequency of balance reduction on a loan affect the cost of borrowing?
— Gurinder Singh, Chandigarh
A. Loans are usually repaid in equated monthly instalments (EMI). The EMI is computed using a method in which the outstanding principal is reduced as you pay and the interest charged on the outstanding balance. Lending companies use different time periods to calculate the outstanding principal.
|Reducing Frequency||Outstanding calculated|
|Annual||After 12 months|
|Quarterly||After 3 months|
|Monthly||With every EMI|
|Daily||With every payment|
In the annual reducing method, though the EMI is paid monthly, the adjustment towards interest and principal is made at the end of the year. This works against the borrower’s interest, because though the principal amount is getting reduced every month, the lender continues to charge interest on the balance that was outstanding the previous year.
Annual reducing loans are rare. The most common ones are monthly reducing loans. In the monthly reducing cycle, the principal is reduced with every EMI and the interest is calculated on the balance outstanding. Most home, vehicle and personal loans are computed on a monthly reducing basis.
There is also a daily reducing method, in which the principal is reduced every day. Of course, this is not always possible because of the impracticality of making daily payments (that is, you don’t repay your loan in equated daily instalments or EDIs!). So, this effectively translates into a monthly reducing balance.
However, the benefit of the daily reducing cycle comes into play when you are prepaying a loan. Suppose your EMI is due on the 7th of every month. A week after paying the EMI, you make a partial prepayment of the loan. In the monthly reducing cycle, your prepayment will be taken into account only when the next EMI is paid. But in the daily reducing cycle, you will get the benefit of the prepayment immediately. The outstanding balance of your loan will get reduced on the 14th instead of the 7th of the next month.
How balance reduction cycles affect your borrowing costs?
|EMIs on a Rs 1 lakh loan for two years at 10%|
|Reducing cycle||EMI||Total payment||Interest outgo|
|All figures are in Rs|
As the table above shows, a borrower’s outgo is lowest in the daily reducing method. In comparison, in the the annual reducing method, he has to pay almost double the interest he pays on a daily reducing cycle.
So in addition to the rate of interest, cost of loan also depends on the frequency with which balance is reduced. This becomes more relevant with longer term loans.
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