EMI – Everything You Wanted to Know About EMIs
EMIs are significant since they help finance anything from a smartphone to an entire apartment. Despite its apparent advantages, many consumers must be aware of the EMI repayment process. This article will help you understand EMI’s meaning and everything you need to know about them.
What is an EMI?
An Equated Monthly Instalment (EMI) is a fixed sum of money paid by the borrower to the lender of funds on a defined day each month for a set time. An EMI comprises two parts: the principal and the interest. Before taking out a loan from any financial institution, the borrower must understand these two components, particularly the calculation of EMI by banks.
No-cost EMIs are one of the most popular EMI repayment methods that ease the pressure of paying a large sum upfront. However, lenders charge a processing fee so you must carefully study all terms and conditions before opting for such loans.
How do EMIs Work?
An EMI is made up of two parts: principal and interest. When a loan is granted to an individual, the interest rate is initially higher than the principal. The loan amount, interest rate, and loan term determine the EMI.
During the first stage of EMI payments, the interest is greater than the principal. However, while the EMIs continue, the principal grows, and the interest shrinks. You can alter the loan duration based on your demands and ability to pay to determine how much EMI is required in each situation and then make a decision.
Types of EMIs
There are two types of EMI payments:
- EMI in Arrears
- Standard EMI.
The entire principal loan amount (after deducting the processing fee) is released by the lender to the borrower’s bank account without any advance EMI payment reduction for EMI in arrears.
Several banks offer standard EMI wherein the principal amount (after subtracting the processing fee and the first EMI amount) is released to the borrower’s bank account. In this case, the advance EMI paid does not include the interest payment but only the principal amount. This reduces the principal loan amount for the remainder of the EMI payments.
How are EMIs calculated?
EMI calculation is mainly of two types:
- The flat rate method
- The reducing balance method
Flat Rate Method
Each interest charge is calculated using the initial principal amount under the flat rate approach when the loan is repaid in instalments. On personal loans and auto loans, the flat rate technique is popular. Borrowers profit less from this plan since interest payments must cover the principal amount, resulting in a higher effective interest rate than the reducing-balance strategy. This technique charges interest on the loan amount, regardless of any previously repaid principal.
Vehicle loan lenders typically use this strategy. EMI = (Principal + Interest)/Monthly Period.
For example, suppose you want to buy a car and take out a loan of Rs. one lakh with a 12% interest rate and a term of 2 years using the flat rate technique. In that case, the interest calculation is on the loan amount of Rs.2 lakhs. As a result, in this case, the EMI would be calculated as follows: EMI = (1000000 + 24000)/24=42666.67.
Reducing Balance Method
Compared to the flat rate method, the declining balance strategy determines the interest payment based on the outstanding principal. This means that the interest and principal payment components of each EMI change. As a percentage of the outstanding loan, interest payments make up a higher amount of the EMI at the start of the loan period.
As you repay your loan over time, the interest amount reduces, and a more significant proportion of the payments go toward principal repayments. Lenders charge interest on the outstanding balance of your loan amount following monthly repayment of the principal amount under this method. The EMIs will remain unchanged in this case, but the interest amount reduces each month.
The formula for calculating EMI using this method is:
P=the principal loan amount
R = monthly rate of interest
N = duration of the loan in months
So, using the same example as in the previous way, the EMI calculation would be:
EMI = [P x R x (1+R)^N]/[{(1+R)^N}-1]. Thus,
EMI = [1000000 x 12/(100 * 12) x (1.01)^24] / [{{1.01)^24}-1]
= 10000 x 1.2697 / 0.2697
=47078.23
Advantages of EMI
Affordable
You can afford high-value products like vehicles through EMIs that would otherwise take a long time to save up.
Convenient
Immediate demands can be met with easy EMIs deducted from your salary account.
Manageable
Rather than paying a large sum from your savings all at once, paying off smaller and regular sums from your monthly salary is better. Thus, EMIs a better method of financial management.
Flexible
EMIs allow you to choose the amount and tenure of repayment. This makes it a convenient and adaptable solution for meeting requirements.
Factors that influence EMI calculation
Loan Amount: The amount borrowed by an individual is an important factor affecting the EMI. The EMI is directly proportional to the loan size; the higher your loan amount, the higher your EMI.
Interest Rate: The interest rate on a loan is calculated by considering the borrower’s income, credit rating, borrowing history, current market conditions, ability to repay, and so on.
Loan Tenure: The third most crucial consideration is the loan’s tenure or length. If you choose a loan with a longer term, your EMI will be lower than if you choose a loan with a shorter period.
Manage your EMIs better
Never missing an EMI is one of the most important things to remember when taking out a loan.
When applying for a loan, carefully consider all possibilities and calculate EMIs in each situation. You can use a loan EMI calculator to aid you with this.
Estimate your financial flows in the future and avoid pressures with EMI payments.
Saving money on small expenses will assist you in better managing your EMI. You can use them to pay off a significant chunk of your loan EMI and save money on interest.
You can avoid excessive fines if you pay your loan EMIs on time. The penalty is determined as a percentage of the skipped EMI. If you have applied for a used car or a home loan, making timely EMI payments will qualify you for a top-up loan.
Conclusion
EMIs are double-edged swords. They help maintain your expenses, but they come with a cost. The longer the loan term, the lower the EMI, but the higher the interest expense you must bear. However, with careful planning and budgeting, you can use EMIs to pay off debt regularly and conveniently. You can benefit from EMIs since the debt is divided. You can schedule your income and expenses carefully and set your EMI payments every month.