Reducing Balance Method
Loan & CreditReducing Balance (Diminishing Balance) Interest Method
An interest calculation method where interest is charged only on the outstanding loan balance, so it shrinks each period as you pay down principal. Nearly all EMI loans use this.
Written by Anurag Rath Ā· Reviewed by the thecalcu.com team Ā· Last updated August 8, 2026
What is Reducing Balance Method?
The reducing balance method calculates interest only on the loan amount still outstanding, not on the original principal you borrowed. As you make payments, the balance shrinks, and so does the interest charged in each subsequent period, even though your EMI itself stays constant.
This is the standard method for nearly all EMI-based loans today, home loans, car loans, personal loans. It contrasts with the older flat rate method, where interest is calculated on the full original amount for the entire tenure, resulting in a much higher effective interest rate than the quoted one.
The amortisation schedule generated by the Home Loan EMI Calculator is built entirely on reducing balance logic, showing exactly how the interest-to-principal split shifts over time.
Formula
Interest for the Period = Outstanding Balance Ć (Annual Rate / 12)
New Outstanding Balance = Previous Balance ā (EMI ā Interest for the Period)
Worked Example
A ā¹10,00,000 loan at 9% annual interest, paid monthly:
- Month 1 interest: ā¹10,00,000 Ć (9%/12) = ā¹7,500
- If the EMI is ā¹20,000, the principal portion that month is ā¹20,000 ā ā¹7,500 = ā¹12,500
- New outstanding balance: ā¹10,00,000 ā ā¹12,500 = ā¹9,87,500
Month 2's interest is then calculated on ā¹9,87,500, slightly less than Month 1, and the cycle repeats until the loan is paid off.
Key Things to Know
- Interest front-loads even under reducing balance. Early payments are still interest-heavy simply because the outstanding balance is largest at the start, not because the method is unfair.
- Effective rate matches the stated rate. Unlike flat rate loans, a 9% reducing balance loan actually costs close to 9% annually, not a much higher effective rate hidden behind the flat number.
- Extra payments compound in your favor. Prepaying principal reduces every future interest calculation for the remaining tenure, not just that one period.
- Almost universal for regulated lending today. Flat rate interest mostly survives in informal or unregulated lending now, reducing balance is the default for bank and NBFC EMI products.
- The math is identical to how a mortgage amortizes in the US. Reducing balance and standard US mortgage amortization are the same underlying method, just described with different regional terminology.