What Is EMI And How Is It Computed?

EMI is an oft repeated term that is associated with any loan taken. Let us understand how EMI works and what are the different aspects associated with EMI. The EMI facility helps the borrower plan his budget. The EMI is calculated taking into account the loan amount, the time frame for repaying the loan and the interest rate on the borrowed sum.

An Equated Monthly Installment (EMI) is usually a fixed amount of money that you need to pay your bank or lender every month as repayment of a loan taken, until your loan is totally repaid. It is essentially made up of two parts, the principal amount and the interest on the principal amount, divided across each month of the loan tenure. The EMI is always paid to the bank or lender on a fixed date each month. This could be done though post-dated cheques issued in favors of the lender or by providing auto debit instructions to your bank for the same.

Here’s the formula to calculate an EMI:

EMI = [P x I x (1+I)^N]/[(1+I)^N-1], where P is the loan amount or Principal, I is the Interest rate per month. [To calculate rate per month: if the interest rate per annum is 14%, the per month rate would be 14/(12 x 100)], and N is the number of installments.

Now, you might assume that the equal parts of the principal and interest are repaid to the financial institution every month. However, this not the case. During the initial years of repayment, the interest component repaid is higher while in later years, the principal component is higher. So, you cannot assume that you will have repaid half of the loan amount once half of the loan tenure is over. A more likely scenario us that you’ve reduced the total interest component that was due by a considerable amount while the principal amount remains to be paid.

Here is a simple example that explains how the repayment of your EMI reduces your loan amount during the repayment period leading up to the end of the loan tenure.

Here the loan amount is Rs. 1, 00, 000, which is lent at an interest rate of 12% with loan tenure of 12 months.

The monthly EMI is calculated at an annualized rate of 12% and amounts to Rs.8, 885 per month with the total interest component amounting to Rs.6, 619.

You will notice that the interest repaid decreases with each passing month while the principal repaid increases at the same time. This means that with a larger loan amount of say Rs.5 lakh and a longer tenure of 20 years, the interest component will form a greater portion of the EMI. This interest portion will reduce leading up to the loan tenure, while the reverse is true for the principal component.

Will the EMI change during the loan tenure?

There are three reasons why your EMI might change during the tenure of your loan.

Interest rate on your loan changes – If you have opted for a floating interest rate, the interest rate on your loan will change whenever the floating rate is reset by the lender. This, in turn, will result in a change in your EMIs. However, note that you can instruct your lender to not to change the EMI and instead request for change in the tenure of the loan.

You prepay the loan – In case you prepay the loan amount during the tenure of the loan, your EMI will change. This is because the principal of the loan will have gone down and the interest due will be based on this new principal. Here too, you can ask your bank to change your tenure instead of the EMI. This will help you repay the loan quickly.

You opt for progressive EMIs – Some lenders offer the option of repaying the loan through staggered EMIs. Here, you pay a fixed EMI for a specific number of years initially and after that term, you start paying larger EMIs. This is generally chosen by young earners who have just started their career and cannot afford to pay large EMIs initially and hope to pay larger EMIs as they grow in their profession.

At the end of the day, loans are liabilities and it is best to close them as quickly as possible, unless you are getting other benefits such as tax exemptions. It is best not to reduce your home loan interest calculation even if interest rates fall.

Source: https://blog.bankbazaar.com/what-is-emi-and-how-is-it-computed/