Glossary
What is Reducing balance interest?
Definition
Reducing balance interest is charged only on the principal still owed, so each period's interest falls as the borrower repays. With equal installments the payment is P × r ÷ (1 − (1 + r)^−n). On 1,000 at 12% over 12 months, interest totals 66.19, against 120 on a flat rate.
There are two common variations. With equal installments the payment is the same every period, but the split shifts from mostly interest to mostly principal. With equal principal, the principal repaid is constant and the payments start higher and decline, which produces slightly less total interest.
Reducing balance is the fairest method for borrowers and the easiest to defend to regulators, and it rewards early repayment because interest stops accruing on principal that has been paid. It is the usual choice for larger and longer loans.
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