When you take a bank loan, you pay the same instalment every month. But inside that fixed amount, the split between markup and repayment changes every month. That is how a reducing balance loan works. Most loans from Pakistani banks use this method, and understanding it can save you real money. This guide explains the idea in simple words, shows the formula, and walks through a month-by-month example.
What Is a Reducing Balance Loan?
In a reducing balance loan, the bank charges markup (interest) only on the amount you still owe. Each instalment pays that month’s markup first. The rest reduces your debt. Next month, the debt is smaller, so the markup is smaller too.
The result is a fixed instalment, called an EMI, with a changing mix:
- In the early months, most of the EMI pays markup.
- Over time, the markup share falls.
- In the last months, almost the whole EMI repays principal.
Banks call the full table of these splits an amortization schedule. Loan documents from major Pakistani banks describe it as the EMI breakup of principal and markup along with the outstanding loan.
The Formula for a Reducing Balance Loan
You need two simple calculations.
1. Monthly markup = Outstanding balance × (annual rate ÷ 12)
2. EMI = P × r × (1 + r)^n ÷ [(1 + r)^n − 1]
Here, P is the loan amount, r is the monthly rate, and n is the number of months. Once you know the EMI, each month works like this: markup is balance times r, principal repaid is EMI minus markup, and the new balance is the old balance minus the principal repaid.
A Month-by-Month Example
Take a Rs500,000 loan for 36 months at 15.39 percent a year. The monthly rate is 1.2825 percent, and the EMI is about Rs17,428. The table shows how the split changes.
| Month | Markup Paid | Principal Repaid | Balance After Payment |
|---|---|---|---|
| 1 | Rs6,413 | Rs11,016 | Rs488,984 |
| 2 | Rs6,271 | Rs11,157 | Rs477,827 |
| 3 | Rs6,128 | Rs11,300 | Rs466,527 |
| 6 | Rs5,688 | Rs11,741 | Rs431,749 |
| 12 | Rs4,755 | Rs12,673 | Rs358,076 |
| 18 | Rs3,748 | Rs13,680 | Rs278,548 |
| 36 | Rs221 | Rs17,208 | Rs0 |
Over the whole loan, you pay about Rs127,420 in markup. The markup is front-loaded. In year one you pay about Rs67,215, in year two about Rs43,765, and in year three about Rs16,440. This is why early repayment saves more than late repayment.
Reducing Balance vs Flat Rate
A flat rate charges markup on the full original loan for the whole period, even after you have repaid part of it. At the same quoted percentage, it costs far more.
| Method (15.39%, Rs500,000, 36 months) | Monthly EMI | Total Markup |
|---|---|---|
| Reducing balance | About Rs17,428 | About Rs127,420 |
| Flat rate | About Rs20,301 | About Rs230,850 |
A 15.39 percent flat rate is equal to roughly 26.6 percent on a reducing balance. Therefore, always ask which method the quoted rate uses.
Why Prepaying Saves Money
Because markup depends on your balance, any extra payment reduces future markup. Suppose you pay Rs100,000 extra after month 12, when the balance is about Rs358,076. You have two ways to use it.
| Option | Result | Markup Saved |
|---|---|---|
| Keep the same EMI | Loan ends in 17 more months instead of 24 | About Rs30,200 |
| Lower the EMI | EMI falls to about Rs12,561 for 24 months | About Rs16,800 |
Keeping the EMI and shortening the loan saves more. These figures ignore any prepayment fee, so check your bank’s rules. Banks often set conditions on partial prepayment. For example, Allied Bank’s personal finance page says partial prepayments are allowed after six months, with a minimum of three instalments.
Daily vs Monthly Calculation
Some lenders calculate markup on the daily outstanding balance, and others on the balance at the end of the previous month. With regular EMIs, the difference is small. It matters mainly when you make an extra payment, because the daily method reflects it immediately. Ask your bank which method it uses and when a prepayment counts.
Floating Rates Change the Schedule
Many Pakistani personal loans are priced at KIBOR plus a spread. When KIBOR resets, the bank recalculates your rate. Your balance still reduces the same way, but the EMI or tenor changes. The spread depends on the bank and the borrower. One major bank lists its personal finance at up to 1-year KIBOR plus 17 percent for salaried applicants and 18 percent for self-employed applicants. Ask for the spread and the reset date in writing. For the full steps with fees included, read our guide on how to calculate markup on a personal loan.
How to Check Your Own Loan
- Ask your bank for the amortization schedule.
- Check that the first month’s markup equals your balance times the monthly rate.
- Confirm that the rate is reducing balance, not flat.
- Check how the bank treats partial prepayment and early settlement.
- Add all fees to the total cost.
Frequently Asked Questions
What is a reducing balance loan?
It is a loan where markup is charged only on the amount still owed, so the markup part of each EMI falls over time.
Is a reducing balance loan cheaper than a flat rate loan?
Yes. At the same quoted rate, a reducing balance loan costs much less than a flat rate loan.
Why is most of my early EMI markup?
Your balance is highest at the start, so the markup charge is highest too.
Does paying extra reduce my total markup?
Yes. Extra payments cut the balance and therefore future markup, subject to your bank’s prepayment rules.
Do Pakistani banks use this method?
Most bank loans, including personal loans, home finance, and car finance, use the reducing balance method. Confirm it in your offer letter.
Conclusion
A reducing balance loan charges markup only on what you still owe, so the interest part of each instalment shrinks as you repay. It costs much less than a flat rate loan at the same quoted percentage, and extra payments save even more. The figures in this article are estimates, so check your own schedule with your bank. This article is for information only and is not financial advice. For more guides on money and daily services, keep following Pakistan Post. You can also check KIBOR rates on the State Bank of Pakistan website.
