Taking a loan is one of the common financial assistances on offer today. To meet essential life goals like automobile or house purchase, education, or
seeking a personal loan in a financial emergency, there is an easy loan available through banks and NBFCs. Loans pay for your needs while you repay your lender by making small monthly payments to settle the loan in a manner that is pocket-friendly to you.
But what is an EMI? How can it impact your budget? What happens to your EMIs when interest rates fluctuate?
Let’s understand these matters in this article.
What are loan EMIs?
An Equated Monthly Installment, or EMI, is the amount of money that you pay back every month to your lender in order to repay your loan. The lending bank or NBFC calculates your loan EMI depending on your loan amount, tenure, and rate of interest.
The EMI comprises of both principal amount and the interest components of your loan and must be paid back on a fixed date as agreed upon between the lender and borrower.
To make it easy for you to repay your loans and also lead a financially stable life, lending institutes usually ensure that loan EMIs are no more than 40-50% of your monthly income.
The ubiquitous EMI
EMIs are not just limited to loans. You can make payments via EMIs for any purchases you may make on your credit cards or various electronic purchases that offer bundled EMI on debit cards.
However, if you opt for the EMI option, you will be paying an additional sum of money either as interest for the loan or as EMI charges as in case of credit or debit card EMIs.
EMIs may mean you have to pay a small amount every month as per your EMI tenure but it also means an increase in the overall cost of ownership of your purchase.
Calculation of EMIs for your loan
If you are a salaried individual, banks and financial institutions offering loans usually ensure that your loan EMI does not cross 30-40% of your monthly income,
assuming you have other debt obligations that consume 10-20% of your monthly income. For self-employed individuals, the amount of profit they
make as per their IT returns or balance sheet submitted during the loan application determines the EMI amount.
Loan EMIs can also be determined using the mathematical formula:
EMI = [ P x R x ( 1 + R ) ^ N ] / [ ( ( 1 + R )^N ) – 1 ]
where P is the principal loan amount, R is the monthly rate of interest for the loan, and N is the number of monthly installments for the loan.
Loan EMIs and loan tenure
Your loan tenure has a direct link with the loan EMI. The higher the tenure, the lower will be your loan EMI but will increase the overall repayment component of your loan.
For example, if you take a car loan for Rs. 5 lakh at a 12.5% rate of interest for 5 years, your loan EMI will come to Rs. 11,249 per month. At the end of your loan tenure, you end up paying Rs. 6.75 lakhs, which is a total interest of Rs. 1.75 lakhs on your principal loan amount.
Now if you increase the tenure from 5 to 7 years, your loan EMI drops to Rs. 8,961, but at the end of your loan tenure, you pay Rs. 7.5 lakh, which is Rs. 2.5 lakh more than the principal amount.
Adhil Shetty, CEO, BankBazaar.com
Reducing or increasing loan EMIs
If, at any point, you plan to prepay your loans where permissible, you have two options. You can either choose to reduce your loan EMIs and keep the tenure
the same or reduce the tenure keeping the loan EMI constant. Usually, by keeping the EMI steady and reducing the tenure, you can pay off the loan faster,
ensuring a lower cost of ownership.
Floating rate loan and their impact on loan EMIs
For loans like home loans offered on a floating rate of interest, any change in interest rates would reflect in your EMI calculations. This means that either the EMI amount itself changes or the tenure of the loan changes. An increase in the rate means a bigger EMI or longer tenure, and vice versa. If you have a floating rate loan, ask for the provision for repayment of loan EMIs should there be a change due to such interest rate fluctuations.
Principal versus interest components of loan EMIs
Loan EMI constitutes payment of both the principal amount as well as the interest amount. Usually, the interest rate component of a loan is higher in initial
loan EMI payments. Gradually, the interest component reduces and the principal component becomes more pronounced as the loan tenure progresses.
For a home loan of Rs. 25 lakh taken at 10.5% rate of interest for 20 years, the loan EMI comes to Rs. 24,959. This does not mean that after first EMI your principal
amount will come down by Rs. 24,949. In fact, for the first EMI your principal component of the home loan EMI is only Rs. 3,084 while the interest component is Rs. 21,875.
When you pay your last EMI, your principal component would be Rs. 24,743 while the interest component would be a paltry Rs. 217.