What is Reducing-balance interest?

With reducing-balance interest, the lender charges interest only on the principal the borrower still owes. As each instalment repays part of the principal, the balance falls and so does the interest in the next instalment. The borrower pays less in total than on a flat-rate loan with the same rate and tenure.

Worked example

A customer borrows ₦600,000 for six months at 3% per month, repaying ₦100,000 of principal each month.

• Reducing balance: month one's interest is 3% of ₦600,000, which is ₦18,000. Month two is 3% of ₦500,000, which is ₦15,000, then ₦12,000, ₦9,000, ₦6,000 and ₦3,000. Total interest: ₦63,000. Instalments fall from ₦118,000 to ₦103,000.
• Flat rate: interest is 3% of the original ₦600,000 every month, ₦18,000 six times. Total interest: ₦108,000, with every instalment at ₦118,000.

The quoted rate is the same, but the flat-rate loan costs the borrower ₦45,000 more. That is why a flat rate looks cheaper than it is, and why the method should always be stated alongside the rate.

Why it matters to a lender

Microfinance banks and lenders often offer both methods on different products. The method has to be applied consistently from the booking screen to the repayment schedule to the interest income in the general ledger; if staff compute it by hand, customers are quoted one figure and charged another.

In Zenus Banking Pro

Each loan type is set to flat-rate or reducing-balance interest. When a loan officer books a loan, the system computes the interest, charges and schedule from the loan type while the form is being filled in, so the figure the customer is quoted is the figure that is posted. Reducing balance uses equal principal each period with interest on the balance still outstanding, as in the example above.