Calculating a reducing balance interest payment is simple and straightforward. The interest rate is stated within the loan agreement. This is applied to the loan principal, which continuously reduces as interest and principal payments are made. If the interest rate is stated as an annual percent rate and payments are made more than once per year, the interest rate must be adjusted to match the number of periods per year payments are made. For example, if the APR is 12 percent, and monthly payments are made, the monthly interest rate equals the APR of 12 percent divided by 12 months, or 1 percent.
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Consider an initial loan amount of $1,000, at 2 percent interest per month for 6 months, with equal monthly installment payments of $178.53 per month. In the first month, interest is equal to the balance of $1,000 multiplied by 2 percent interest, or $20. In Month 1, the installment payment of $178.53 was allocated as: $20 to interest and principal reduction of $158.53.
This means that at the beginning of Month 2, the loan balance equals $1,000 minus the loan reduction of $158.53, or $841.47. Interest expense equals 2 percent multiplied by $841.47, or $16.83. The loan reduction this time is equal to $178.53 minus interest expense of $16.83, or $161.70. Continuing this exercise through Month 6 results in total loan reduction of $1,000 and total interest expense paid of $71.15, the sum of which happens to equal $1071.15. This figure, $1071.15, also is equal to the sum of the six monthly installment payments of $178.53.