The reducing balance method (also called diminishing balance) is the standard method for calculating interest on retail loans in India. Unlike the flat interest method, where interest is computed on the original principal for the entire tenure, reducing balance calculates interest only on the outstanding principal at the start of each month. As you repay principal, the interest portion of subsequent EMIs falls.
This is why an EMI calculated using reducing balance is lower in total interest than the same loan under flat interest, even at the same nominal annual rate.
Worked example
A ₹10,00,000 loan at 8% p.a. for 12 months:
- Reducing balance EMI: ₹86,988 → total interest ≈ ₹43,861
- Flat interest EMI: ₹89,933 → total interest = ₹80,000
The Reserve Bank of India mandates reducing balance disclosure for all retail loans.