An Equated Monthly Installment, popularly known as EMI, is a payment made by a borrower to the lender. This payment is constant or fixed and is made on a pre-determined date every month.
The EMI consists of both the interest and the principal and when paid over the course of a few years, it helps clear off the loan.
Before you understand more about what an EMI is, here are a few terms that are commonly used while discussing loans. The sum of money that is borrowed is called the principal.
The cost of borrowing money is known as interest, which is the amount you pay for availing of a loan.
The tenure is the duration for which you take the loan. It may range from a few days or months to a few years.
Moreover, the rate of interest you pay is pre-determined based on several factors.
What is no-cost EMI?
Largely, EMIs are paid with an interest. It is the interest that enables the financial institution to earn money on the amount they lend.
However, sometimes you do not have to pay the interest on the principal. These loans are split into no-cost EMIs. These are generally offered by retailers and e-commerce marketplaces on consumer durables and electronic appliances.
How does an Equated Monthly Installment (EMI) work?
Remember that EMIs are not the same as variable payment plans. In the case of the former, the borrower must pay a fixed amount every month.
However, in the latter, the borrower may choose to pay a higher amount based on his/her discretion.
Most borrowers find the former beneficial because they know the exact EMI payment they must make every month. This helps them plan their finances in advance.
Moreover, lenders rest assured that they have a reliable avenue to make a fixed amount of income every month by way of interest.
How is EMI calculated?
The Flat Rate Method
The Flat Rate Method is popularly applied to a personal loan EMI calculation and sometimes, to auto loans as well.
Under this method, it is the original principal amount that is considered for the calculation of the EMI.
The interest is calculated on the principal amount, then added to the entire amount, and the sum is divided by the number of installments to be paid during the tenure of the loan.
In this method, since the interest must cover the whole principal amount, the effective interest rate is much higher than the Reducing Balance Method, which puts the borrowers at a disadvantage.
The Reducing Balance Method
The Reducing Balance Method is applied to home mortgages, credit cards, and others. This method works differently from the Flat Rate Method.
Here, the component of interest is calculated based on the outstanding principal amount and not the entire principal amount.
As a result, every month, you pay a different component of interest and principal payment. Typically, the interest section of the EMI is larger in the initial stages of repayment.
As the loan is repaid, this component becomes smaller, and a larger part of the installment is allocated to the repayment of the principal amount.
You may use an online EMI calculator to estimate the installment amount and make an informed decision.
Principal and interest rate amount calculation
To calculate the amount that you are paying against the principal every month, you may use the following formula.
E = P x [r x (1+r) ^ n] / [(1+r) ^ n] - 1 where
E is the EMI
P is the principal loan amount
r is the rate of interest
n is the loan duration
Once you know your EMI, you can calculate the interest component using the formula
Interest component = P x r where
P is the amount of principal remaining
r is the periodic interest rate
Now, you may calculate the principal component by subtracting the interest component from the EMI.
Examples of Equated Monthly Installments (EMIs)
To gain a better understanding of how EMIs work, let us look at a couple of examples.
Here, EMI calculation will be done based on both the Flat Rate Method and the Reducing Balance Method.
Let’s say Mr. Singh wants to purchase a house. He already has some money saved up, and for the rest, he has decided to avail of a home loan.
The principal amount of the loan is INR 50 lakhs, the interest rate is 7%, and the tenure is 20 years
Using the Flat Rate Method
Now, if you are to calculate the EMI based on this method, then you need to add the principal to the interest component and divide the final figure by the number of periods multiplied by the number of months. So, that will be
INR [50,00,000 + (50,00,000 x 20 x 0.07)] / (20 x 12) = INR 50,000
So, Mr. Singh has to pay an EMI of INR 50,000 per month in which the principal and the interest amount remain the same every month.
Using the Reducing Balance Method
On the other hand, if you are to calculate the EMI using this method, you must use the formula:
INR 50,00,000 x [0.0058 x (1 + 0.0058) ^240] / [(1+0.0058) ^120 - 1] = INR 38,765
As per this method, Mr. Singh has to pay only INR 38,765 per month. The principal and the interest parts of the EMI vary every month because the interest charge is calculated on the principal that is outstanding and not on the total principal.
Therefore, this method proves to be more cost-effective to borrowers.
Different components of EMIs
Any EMI has two components - the principal and the interest.
At the beginning of the repayment tenure, the component of interest is much higher.
But as the EMI payments go by, the interest component reduces while the principal component makes up for the larger part of the EMI.
Factors that affect the interest rate and the EMI
The main factors that influence the EMI are as follows:
The principal is the amount of loan that a person borrows from a lender. The EMI is based on the principal amount and is directly proportional to it. So, the higher the principal, the bigger will be the EMI.
The rate of interest
The rate of interest is the rate that is charged by banks or non-banking financial institutions (NBFCs) for providing the loan. The rate depends on a variety of factors, including the borrower’s credit history and profile.
The interest rate is influenced by the following.
The higher the supply, the lower will be the interest rate.
The higher the demand, the higher will be the interest rate.
If the government is facing a fiscal deficit, it will borrow more and that will raise the interest rates.
If the prices of goods and services rise, the interest rate will also rise.
- Global and foreign exchange rates
To attract large foreign investors and to support foreign exchange, a higher interest rate might be appropriate.
If the Reserve Bank of India (RBI) decides to curtail inflation, it might raise interest rates to limit the consumption of goods supported by borrowed money.
The tenure is the period within which the entire loan, including the interest, needs to be repaid to the lender. A longer tenure implies a higher interest outflow.
What is the difference between full-EMI and pre-EMI?
Full-EMI refers to the payment of both the principal and the interest. On the other hand, pre-EMI refers to the payment of just the interest.
When the loan is being disbursed, the borrower may choose to pay just the interest component before the repayment period begins. Since the pre-EMI is paid before the repayment, it is not considered in the tenure of the loan.
Does the EMI change during the tenure?
Generally, the EMI remains constant. However, it may change in certain cases. These are as follows:
Floating interest rates
If a loan is based on a fixed interest rate, then the EMI remains the same every month. However, if it is based on a floating interest rate, then the EMI will change with the changes in the interest rate.
There are several banks and NBFCs that allow borrowers to repay a lump sum against the outstanding loan amount. In this case, the EMI will reduce to reflect the diminished outstanding principal. However, this may entail some charges.
With such loans, the EMI starts off at a certain amount and then rises after a specific period. This usually happens with longer-term loans.
Frequently Asked Questions (FAQs)
Are EMIs good or bad?
For big-ticket purchases like a car or a house, availing of a loan and paying a fixed amount of money every month is more convenient and it also entails tax benefits.
However, resorting to EMIs for every purchase might not be ideal. At the end of the day, you are paying more for the product or service by means of interest, processing fees, and hidden charges.
So, EMIs are neither good nor bad but are circumstantial.
Is there any GST levied on the EMI?
No, you need not pay Goods and Services Tax (GST) on your EMI. However, the bank or lender may levy GST on the processing fees or other charges.
Are loan and EMI the same?
No, they are not. A loan is an amount that a borrower takes from a lender in return to repay that amount with interest over a certain period.
An EMI is a medium through which the loan amount is repaid to the lender.
What are the consequences of non-payment?
Frequent non-payments or delayed payments can have a negative impact on your credit score. One or two missed payments may not be considered to classify someone as a defaulter.
However, in the case of more than three consecutive non-payments, the bank might send reminders, and in case of missed reminders, the bank might even send a legal notice.
This is a companion discussion topic for the original entry at https://jupiter.money/resources/equated-monthly-installment-emi/