Understanding the reducing balance method

The reducing balance method, also known as the declining balance method, is a popular approach to calculating interest on loans and a technique for depreciating assets. Its unique feature is that interest or depreciation is calculated on the outstanding balance, making it a fair and dynamic system. This article explores how the reducing balance method works, its applications, advantages, and considerations.

What Is the Reducing Balance Method?

The method involves calculating interest or depreciation on the remaining principal balance rather than the original loan amount or asset value. This means that as payments are made or as the asset’s value reduces, the amount of interest or depreciation decreases over time.

How the Reducing Balance Method Works for Loans

1. Initial Loan Amount
   The borrower takes a loan, and the lender calculates interest on the full loan amount during the first period.
2. Subsequent Periods
   After each payment, the principal amount decreases, and interest for the next period is calculated on the reduced principal balance.
3. Formula for Interest Calculation

   Interest=Outstanding Principal×Interest Rate×Loan Tenure (in months)​/12

   ​ExampleSuppose a borrower takes a loan of Sh100,000 at an annual interest rate of 10% for 3 years, with monthly repayments.

   • First Month: Interest = 100,000×10%×112=Sh833.33100,000 \times 10\% \times \frac{1}{12} = Sh833.33100,000×10%×121​=Sh833.33
   • After the first payment, if Sh5,000 is paid toward principal and interest, the new balance becomes $100,000-(5,000-833.33)=Sh95,833.33$.
   • Second Month: Interest = 95,833.33×10%×112=Sh798.6195,833.33 \times 10\% \times \frac{1}{12} = Sh798.6195,833.33×10%×121​=Sh798.61.

Application in Depreciation

In asset management, the reducing balance method is used to allocate higher depreciation in the early years of an asset’s life and lower depreciation in later years.

1. Depreciation Formula

   $$\text{Depreciation Expense}=\text{Net Book Value}\times \text{Depreciation Rate}$$

2. Example
   An asset purchased for Sh50,000 with a depreciation rate of 20%:
   • Year 1: Depreciation = $50,000\times 20\%=Sh10,000$. Remaining value = Sh40,000.
   • Year 2: Depreciation = $40,000\times 20\%=Sh8,000$. Remaining value = Sh32,000.

Advantages of the Reducing Balance Method

1. Fair to Borrowers
   Interest payments decrease over time as the loan principal reduces, ensuring that borrowers do not pay excessive interest.
2. Promotes Faster Loan Repayment
   The method encourages early repayment of loans by reducing interest burdens over time.
3. Reflects Real Asset Value
   For depreciation, it mirrors the actual usage and wear-and-tear of an asset, which is higher in the initial years.
4. Transparent and Straightforward
   Borrowers and asset owners can easily track the impact of payments or usage over time.

Disadvantages of the Reducing Balance Method

1. Borrowers face higher repayments initially, which might strain their finances.
2. Calculating reducing balance interest or depreciation may be more complex compared to flat rate methods, especially for larger portfolios.
   For businesses using this method for accounting, inconsistent depreciation expenses can impact financial projections.

Comparing Reducing Balance to Flat Rate Method

When to Use the Method

1. For Loans
   This method suits borrowers who prefer fair and transparent interest calculations. It’s common in mortgage and vehicle loans.
2. For Asset Depreciation
   Businesses looking to align depreciation with asset usage often prefer this method, especially for high-value equipment or vehicles.

Author: Andrew Walyaula

Andrew Walyaula is a seasoned multimedia journalist. waliaulaandrew0@gmail.com