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Each of the methods, annual, monthly and daily reducing, offers different advantages and suits different types of borrowers.
Know How Home Loan Interest Is Calculated. Check Factors That Influence the Rate
Buying a home is a significant milestone for many, and home loans are often the primary financial tool used to make this dream a reality. In India, understanding how the interest on a home loan is calculated is crucial to managing your repayments effectively. Here, we break down the common methods used by banks and financial institutions to calculate home loan interest.
Banks typically calculate interest on home loans using one of three methods: monthly reducing balance, yearly reducing balance, or daily reducing balance.
For instance, the State Bank of India calculates interest on a daily reducing balance.
How Home Loan Interest Is Calculated?
The Annual Reducing Method, Monthly Reducing Method, and Daily Reducing Method are different approaches to calculating interest on loans, including home loans. These methods determine how frequently the outstanding principal amount (the amount on which interest is charged) is updated.
Here’s a detailed explanation of each:
Annual Reducing Method: In this system, the principal on which interest is calculated reduces only at the end of the year. As a result, you continue to pay interest on a portion of the principal that you’ve already repaid. This makes the EMI under the monthly reducing method effectively lower than that of the annual reducing method.
For example, if you take a loan of Rs 30 lakh at an 8% annual interest rate for 20 years, the interest will be charged on the outstanding balance at the end of each year. However, repayments made during the year will not reduce the interest calculation until the end of the year.
Monthly Reducing Method: In this system, the principal on which interest is charged reduces each month as you make your EMI payment.
For example, if you borrow Rs 30 lakh at 8% interest annually, the interest is charged on the outstanding balance of Rs 30 lakh in the first month. After the first EMI is paid, the principal is reduced, and the interest for the second month is calculated on the new outstanding balance.
Daily Reducing Method: In this system, the principal on which interest is charged decreases as soon as you make your EMI payment. As a result, the EMI under the daily reducing method is lower compared to the monthly reducing method. Additionally, a year is considered to have 365 days, regardless of whether it’s a leap year or not.
For example, if you have a Rs 30 lakh loan and make a repayment of Rs 1 lakh, the outstanding balance reduces to Rs 29 lakh, and interest will now be charged on Rs 29 lakh from the next day onward. In the case of daily compounding, even small changes in the loan balance can reduce the overall interest burden.
| Method | Principal Update Frequency | Interest Cost | Borrower Benefit |
| Annual Reducing | Once a year | Highest | Least borrower-friendly |
| Monthly Reducing | Once a month | Moderate | More favourable |
| Daily Reducing | Daily | Lowest | Most borrower-friendly |
Factors Affecting Home Loan Interest Rates
The interest rate on a home loan depends on several factors:
- Loan Amount: Larger loan amounts might attract different interest rates.
- Loan Tenure: A longer loan tenure may result in a lower EMI but a higher overall interest cost.
- Credit Score: Borrowers with a higher credit score may qualify for a lower interest rate, as they are considered less risky by lenders.
- Lender’s Policies: Different banks and financial institutions may offer varying rates based on their criteria, competition, and market conditions.
- Fixed vs. Floating Rate: Home loans can either have a fixed or floating interest rate. With a fixed-rate loan, your interest remains constant throughout the loan tenure. With a floating-rate loan, the interest rate can fluctuate based on changes in market conditions.
Each of these methods – annual reducing, monthly reducing, and daily reducing – offers different advantages and suits different types of borrowers. The daily reducing method is the most efficient in terms of minimising interest payments, while the annual reducing method can lead to higher interest costs. The monthly reducing method is a popular middle ground, balancing convenience and cost-effectiveness. When choosing a home loan, it is essential to understand how interest is calculated and select the method that aligns with your repayment capacity and financial goals.
