Understanding Reducing Balance Loans: A Comprehensive Guide

Most consumer loans have fixed monthly payments.

Most consumer loans are reducing balance loans that have constant periodic payments. In the early stages of such loans, most of the payment goes toward interest. The principal repayment gradually increases each month as the interest payment gradually declines. Other loans have fixed periodic principal payment amounts, added to which is the current month's interest payment. The principal repayment amount remains fixed, which means that the total payment each month is greatest in the first month, gradually declining thereafter. Both loans are versions of the "reducing balance method." Another kind of loan, more common in microfinance than in domestic consumer loans, is the flat rate loan, in which loan interest payments remain constant over the course of the loan.

Reducing Balance Loan Calculation

The interest payable per installment on a reducing balance loan with a fixed monthly payment equals the interest rate per installment times the amount currently owing on the loan. For example, if you make monthly payments on a loan with a 6 percent annual interest rate and the balance before the current month's payment is $30,000, the interest due equals 6 percent divided by twelve -- the number of months in a year -- times $30,000, which equals $150.00. If the loan has a fixed total monthly payment, the principal reduction portion equals the monthly payment minus the interest due.