25 Sep, 2011 10:36 AM

Know the EMI

Home loan, Car loan... Lot of loans to avail. Lot of advertising about the EMI rates. But how much have you understood about the EMI? - its equated monthly installment, EMI. So what is this EMI and how is it calculated?

What is an EMI?

The EMI stands for equated monthly installment, or the EMI, is the amount of money we have to pay month;y to the bank or the to the lender towards clearing the loan.

EMI payments are made every month, for the entire tenure of the loan, till the outstanding amount is completely repaid.

EMI break-up
The EMI that we pay are broken in components of the principal and interest. In the initial years of the loan, a major portion of the EMI goes towards the interest. As time advances, principal gets paid, the balance loan amount reduces. Hence the interest component thus reduces. The EMI, though, stays as a constant amount each month.

The EMI of a home loan is determined by the following four factors:

The principal amount.
The rate of interest.
The tenure of the loan.
Method of computation: daily, monthly or on annual reducing basis.

Annual reducing method: Though the EMI is paid monthly, the adjustment of principal and interest is made at the end of the year. The main drawback of this method is that borrowers continue to pay interest on a portion of the principal that has already been paid back to the lender.
Monthly reducing loans: The better and most common method, it reduces the principal with every EMI paid, each month. The interest is calculated on the outstanding balance.
Daily reducing loans: Reduces the principal every day, with daily loan payments. Interest is charged on the outstanding balance. Practically, of course, such daily payments are not feasible, hence this method isn't popular.

Calculation

EMI is calculated using the formula mentioned below.

EMI = (Loan amount x interest) x (1 + Interest)^n / [(1 + Interest)^n] -1

Interest = (per cent rate)/12

n = Loan period in months

For example, let's calculate the EMI for a loan of Rs 10,00,000 at 11% annum interest rate and loan tenure of 20 years.

Loan amount = Rs 10,00,000

Monthly interest = 0.11/12 = 0.0092

n = 20 years, that is, 240 months

EMI = (10,00,000 X 0.0092) X (1+0.0092)^240 / [(1+ 0.0075)^240]-1

EMI = Rs 11391.10

This EMI of Rs 11391.10 is the sum of both the interest and principal portion of the loan, to be paid every month.

The loan amortisation schedule is a table containing home loan information such as period of scheduled payments, amount borrowed and amount outstanding. It also details the breakup of every EMI towards repayment interest and the outstanding principal of the loan.

The amortisation table is prepared with the use of financial mathematics by financial institutions. It could help borrowers make vital decisions about their loan, on prepayment or refinance. It also provides details of interest for tax related benefits.

Home loan borrowers sometimes seek a partial disbursement of their home loan on the basis of the stages of construction of their house. In such cases, a pre-EMI is to be paid, every month till the final loan is disbursed. The real loan repayment would commence only after the entire loan is disbursed. This pre-EMI would therefore comprise of only the interest accrued on the disbursed money.

EMI on fixed rate of interest

Fixed interest rate loans, charge a steady interest rate throughout the tenure of the loan. The EMI therefore remains constant during the tenure of the loan. It is generally better to opt for a fixed rate only when the prevailing interest rates have reached rock bottom levels and if an upward trend is anticipated.

EMI on floating rate of interest

Floating rates, move with the market lending rates and thus prone to fluctuations. The EMI would increase or decrease depending on the interest rate movement. Alternatively, banks may also provide an option to increase the tenure of the loan, at a constant EMI, for borrowers who do not desire their EMI to be increased in case of higher interest rates

Points to Note

Consider the various personal milestones before committing to any lender. Expenditures on an additional family member, children, etc. should be factored in when deciding on your EMI.

Financial institutions offer various schemes to attract potential borrowers. One must read the fine print of the documentation carefully to understand the effective rate of interest and other terms and conditions of the loan.

One should avoid stretching beyond one's capacity to pay. Factor in for interest rate fluctuations and other debt obligations, when arriving at the EMI.

With uncertainties in life and job, it may be better to repay one's debt sooner. Consider the prepayment option if possible, to reduce the debt obligation.

Avoid EMI defaults, by keeping in mind the date at which the EMI is to be paid. Maintain an adequate balance in your account on the relevant date so that the EMI payment is made successfully.