A Reducing Balance Loan Calculator is a tool used to estimate the repayment schedule of a loan where interest is calculated on the outstanding principal balance. This means that with each payment you make, a portion goes towards the interest and a portion towards the principal. As the principal balance decreases, the amount of interest you pay also reduces over the loan term.
Here’s a detailed breakdown with an example:
How a Reducing Balance Loan Works
- Initial Loan Amount (Principal): This is the amount of money you borrow.
- Interest Rate: This is the cost of borrowing, usually expressed as an annual percentage.
- Loan Term: This is the period over which you agree to repay the loan, typically in months or years.
- Monthly Payments (EMI – Equated Monthly Installment): These are the fixed amounts you pay regularly (usually monthly) that cover both the principal and the interest.
Example:
Let’s say you take a loan of KSh 100,000 at an annual interest rate of 12% for a term of 3 years (36 months).
Using a reducing balance method, the calculator would work as follows:
- Month 1:
- Interest for the month = (Outstanding Principal * Monthly Interest Rate) = (KSh 100,000 * (12%/12)) = KSh 1,000
- A portion of your EMI goes towards this interest, and the rest reduces the principal.
- Let’s assume your EMI is calculated to be KSh 3,321 (this is a simplified illustration; the actual EMI calculation is more complex but readily done by calculators).
- Principal repaid in Month 1 = (EMI – Interest) = (KSh 3,321 – KSh 1,000) = KSh 2,321
- Outstanding Principal at the end of Month 1 = (Initial Principal – Principal Repaid) = (KSh 100,000 – KSh 2,321) = KSh 97,679
- Month 2:
- Interest for the month = (New Outstanding Principal * Monthly Interest Rate) = (KSh 97,679 * (12%/12)) = KSh 976.79
- Principal repaid in Month 2 = (EMI – Interest) = (KSh 3,321 – KSh 976.79) = KSh 2,344.21
- Outstanding Principal at the end of Month 2 = (KSh 97,679 – KSh 2,344.21) = KSh 95,334.79
As you can see, the interest component of your EMI decreases each month because it’s calculated on a smaller outstanding principal balance. The principal repayment portion of your EMI, therefore, increases over time, allowing you to pay off the loan faster in the later stages.
Most online loan calculators will provide you with an amortization schedule, which is a table showing the breakdown of each payment into principal and interest, and the remaining balance for each month of the loan term.
Differences Between Fixed and Reducing Balance Loan Calculation for Banks in Kenya
In Kenya, banks typically offer loans with either a fixed interest rate or a reducing balance interest rate. The way interest is calculated significantly impacts the total cost of the loan and the repayment schedule. Here are the key differences:
| Feature | Fixed Interest Rate Loan | Reducing Balance Interest Rate Loan |
| Interest Calculation | Interest is calculated on the original principal loan amount throughout the entire loan tenure. This means the interest component of your monthly payment remains the the same, regardless of how much principal you have repaid. | Interest is calculated on the outstanding principal balance after each payment. As you repay the principal, the interest charged in the subsequent periods reduces. |
| Monthly Payments (EMI) | The total monthly payment (principal + interest) remains constant throughout the loan term. While the total EMI often remains constant, the proportion of principal and interest within the EMI changes. In the early stages, a larger portion goes towards interest, and in the later stages, more goes towards principal. | |
| Total Interest Paid | Generally, you end up paying more total interest over the life of the loan compared to a reducing balance loan of the same principal, interest rate, and tenure. This is because you are paying interest on the initial large principal amount for the entire duration. | You pay less total interest over the loan term because the interest is calculated on a progressively smaller outstanding balance. |
| Transparency | The calculation is simpler to understand initially as the interest component is straightforward. However, the effective interest rate (the actual cost of borrowing when considering the decreasing principal) is often higher than the stated fixed rate. | The interest calculation is more complex as it changes each period. However, it is generally considered more transparent in reflecting the true cost of borrowing as you only pay interest on the money you still owe. |
| Early Repayment | Making extra payments or fully prepaying a fixed interest loan might not significantly reduce the total interest paid, depending on the bank’s policy, as the interest was already calculated on the initial principal. Some banks may still charge penalties for early repayment. | Making extra payments or prepaying a reducing balance loan leads to a significant reduction in the total interest paid as it directly reduces the outstanding principal on which future interest is calculated. Prepayment penalties might still apply depending on the bank’s terms. |
| Initial Payments | The principal repayment in the initial months is lower compared to a reducing balance loan with the same EMI. | The principal repayment in the initial months is also lower, but the interest portion is higher compared to later payments. |
| Common Use in Kenya | Historically used for some personal loans and smaller value loans due to its simplicity in calculation. However, it’s becoming less common as borrowers become more aware of the benefits of reducing balance. | More commonly used for larger loans like mortgages, car loans, and business loans in Kenya due to its fairness to the borrower over the long term. |
Example to Illustrate the Difference (Simplified):
Assume a KSh 100,000 loan at 10% per annum for 2 years (24 months).
- Fixed Interest: The total interest might be calculated as (100,000 * 10% * 2) = KSh 20,000. This interest is then spread over 24 months, resulting in a fixed interest component per month. The principal is also divided equally over 24 months. The EMI remains constant.
- Reducing Balance: The interest in the first month is calculated on KSh 100,000. After the first payment, the principal reduces, and the interest for the second month is calculated on the new, lower principal, and so on. The EMI might be structured to be slightly higher initially than the interest, ensuring the principal gradually reduces. The interest component of the EMI decreases over the 24 months.
In conclusion, a reducing balance loan calculator helps borrowers understand the dynamics of their loan repayments where interest decreases over time as the principal is paid down. When choosing a loan in Kenya, it’s crucial to understand whether the interest is calculated using a fixed or reducing balance method, as this will significantly impact the total cost of the loan and the repayment schedule. The reducing balance method is generally more favorable for borrowers in the long run as it results in lower overall interest payments. Many banks in Kenya now offer online loan calculators that show the amortization schedule for reducing balance loans, providing transparency to borrowers.