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CS Professional · Banking and Insurance - Laws and Practice · Calculation of Interest and Annuities

Suresh has a home loan from a bank with a fixed monthly EMI on a reducing-balance basis at a constant interest rate. He compares his second EMI with his first EMI. Which statement is correct?

In a fixed-EMI reducing-balance loan, the second EMI has a lower interest component and a higher principal component. Interest is calculated on the falling outstanding balance, and because the total instalment is constant, the amount not needed for interest goes to repaying principal.

  1. AThe interest component is lower and the principal component is higher in the second EMICorrect
  2. BThe interest component is higher and the principal component is lower in the second EMI
  3. CBoth interest and principal components are the same in every EMI
  4. DThe interest component stays the same but the principal component rises

Explanation

On a reducing-balance loan, interest is charged on the outstanding principal. After the first EMI the outstanding principal falls, so the interest in the second EMI is lower. Since the total EMI is fixed, the balance of the instalment repays more principal. The opposite pattern would apply only if the balance were rising.

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