How Interest is Calculated on Home Loans: Daily vs Monthly Reducing Balance Methods

Home loans are generally for significant amounts and for long tenures, so the interest you pay will likely be higher than for small amounts or short tenures. While the rate of interest on a home loan has a significant impact on the total interest, the method that the institute uses is of equal importance. That’s why understanding how your bank calculates interest isn't just a detail; it’s the difference between saving or spending a significant amount of money over the long haul.

What is the Rate of Interest on Home Loan?

The interest rate is just the yearly charge you pay to borrow money from the bank. It varies with things such as your CIBIL score (your credit report), the loan term, and the type of lender. However, a more critical factor is the calculation method, which often gets overlooked.

How is Interest Calculated on a Home Loan?

Every month, you pay a fixed amount, commonly known as EMI, which consists of two parts: Principal (the amount you borrowed) and Interest (the fee).

The calculation employs a complex formula, but what you need to know is that initially, most of your EMI is allocated toward interest. As the loan progresses, the principal portion increases. The way the interest portion is calculated is where the two methods differ.

What is the Daily Reducing Balance Method?

This is the most borrower-friendly method. The interest is recalculated daily on the loan amount you still have outstanding.

The Benefit: Whenever you pay a prepayment on any given day, the amount outstanding goes down right away, and the bank charges interest on the reduced amount from the very next day. This speeds up your principal repayment and reduces your overall interest paid by a huge amount.

What is the Monthly Reducing Balance Method?

This is the usual procedure with most Indian banks and Housing Finance Companies (HFCs). The interest is only recalculated once a month, usually immediately after your regular EMI payment.

The Drawback: When you prepay partially, that amount remains idle, and the interest on the original higher principal runs till the subsequent monthly calculation date. For those few weeks, you end up paying more interest than you need to.

Daily vs Monthly Reducing Balance: What’s the Difference?

The difference lies in how quickly your loan principal is acknowledged as paid down.

Feature

Daily Reducing Balance

Monthly Reducing Balance

Interest Charged

Calculated every day.

Calculated once a month.

Repayment Benefit

Instant principal reduction upon any prepayment.

Principal reduction takes effect monthly.

Savings Potential

Maximum savings, especially with prepayments.

Standard savings, less benefit from mid-month payments.

For a ₹50 Lakh loan at 8% over 20 years, the daily reducing balance method can save you significant amount in total interest.

Which Method Gives the Lowest Interest Rate Home Loan?

The daily reducing balance method is always better for the borrower, as it immediately applies any reduction in your loan balance.

However, since the monthly reducing balance method is simpler for banks' accounting, it is the more common standard in India. You must always confirm the calculation method with your bank.

How to Do a Home Loan Comparison Effectively

• Beyond the Rate: Don't just compare a loan's interest rate and calculation basis. A marginal higher rate with daily reducing basis may prove to be less expensive than a lower rate but monthly reducing basis.

• Use Calculators: Use online EMI calculators to model your loan, but assume a monthly reduction unless the bank explicitly confirms daily.

• Check All Costs: Your focus should be on the effective cost of borrowing, which includes the interest, processing fees, and any prepayment or foreclosure charges.

Conclusion: Choosing the Right Loan

The daily reducing balance saves you more money, but the monthly reducing balance is the industry standard. Be a smart borrower: always check the rate, the calculation method, and all the hidden costs together before finalizing your home loan.

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