How to Calculate Reducing Balance Loan

Calculating a reducing balance loan shows how loan payments are divided between interest and principal.

A reducing balance loan calculates interest payments off the remaining principal of the loan. Part of a loan payment goes toward the principal on the loan and part of the payment goes toward the interest on the loan. Since part of the payment goes toward the principal, the principal will decrease with each payment. This in turn will decrease the amount of interest due each payment.

Instructions

Calculating the Payment

1. Determine the interest rate on the loan, the length of the loan and the amount of the loan. Use the example of a $100,000 loan at 6 percent annual interest that must be repaid in 20 years.

2. Divide the interest rate by 12 to determine the interest rate per month. In the example, 6 percent divided by 12 months equals 0.5 percent or 0.005.

3. Add one to the interest rate per month. In the example, 1 plus 0.005 equals 1.005.

4. Raise the number calculated in Step 3 to the power of the number of payments required on the loan. In the example, since the loan is due in 20 years, you must multiply 20 years by 12 months to determine the total number of payments. The total number of payments then is 240. So, 1.005 raised to the power of 240 equals 3.310204476.

5. Subtract 1 from the number calculated in Step 4. In our example, 3.310204476 minus 1 equals 2.310204476.

6. Divide the interest rate per month by the number calculated in Step 5. In our example, 0.005 divided by 2.310204476 equals 0.002164311.

7. Add the interest rate per month to the number calculated in Step 6. In our example, 0.002164311 plus 0.005 equals 0.007164311.

8. Multiply the number calculated in Step 7 by the principal on the loan. In our example, 0.007164311 times $100,000 equals $716.44.

Breaking the Payment Down

1. Multiply the outstanding principal by the interest rate per month. In our example, $100,000 times 0.005 equals $500. This is the amount of interest paid on the first payment.

2. Subtract the interest paid from the monthly payment. In our example, $716.44 minus $500 equals $216.44 paid toward principal on the first payment.

3. Subtract the principal paid from the remaining principal to determine the new remaining principal. In our example, $100,000 minus $216.44 equals $99,783.56.

4. Repeat these steps for the 240 payments. With each payment the principal paid will increase and the interest paid will decrease because the principal is reduced with each payment.

References

• Oak Road Systems: Loan or Investment Formulas
• Cashonomics: Loan Calculator
• 1728: Loan Payment Formula

Resources

• Read this Article in Spanish