The Reducing Balance Method is mainly used to calculate the total interest for housing or mortgage property loans wherein the interest to be paid by the customer is calculated based on the outstanding loan amount after periodic repayments. Being the preferred option compared to the Fixed Interest Rate, Reducing Balance Rate or the Diminishing Rate is used to calculate the interest amount for overdraft facilities and credit cards as well. This method is beneficial to the customers since they have to pay less amount of interest as the loan tenure progresses considering that the interest is calculated based on the outstanding principal loan amount. In this method, the interest decreases after each monthly installment is paid since the remaining balance becomes lesser than the previous month with the payment of each EMI. The depreciation rate percentage is applied on reducing balance of asset.
The formula for the Reducing Balance Method can be represented as,
Amount of interest for each installment = Applicable rate of interest * Remaining loan amount
Advantages of the Reducing Balance Method
There are numerous significant advantages to the Reducing Balance Method. Learn about the advantages of the
- This method is simple to implement and easy to understand.
- For businesses, the amount which is charged to the profit & loss account towards depreciation and repairs remains somewhat uniform as the period of the loan progresses.
- The Reducing Balance Method is acceptable for income tax purposes. The depreciation tax deduction can be claimed in a larger amount.
- This method does match the cost and revenue of any business. The greater amount of depreciation during the initial years which is matched against the higher amount of revenue that is generated by the increased production by using a new asset.
Disadvantages of the Reducing Balance Method
There are very few disadvantages of this method which are mentioned in the list below:
- The Reducing Balance Method charges a heavy amount of depreciation during the initial years.
- The rate of depreciation can only be calculated if there is some residual value of the asset.
