Today, we have a loan for just about everything, be it a house, car, foreign trip and even a mobile.
- The ‘loan culture’ has caught on in a big way. A majority of people have availed of loans at some point or the other.
- But do we really know how the EMI on the loan is calculated?
What is an EMI?
- An Equated Monthly Installment (EMI) is the amount paid by a borrower each month to lender of the loan.
- The EMI is an unequal combination of principal (the actual loan you have taken) and interest rate.
- EMI payments are made every month, generally on a fixed date, for the entire tenure of the loan, till the outstanding amount has been completely repaid.
Factors Affecting EMI
The key factors affecting your overall EMI amount payable include the following:
Loan Principal: The higher the amount borrowed as a loan, the higher will be your EMI as long as the tenure and interest rate remain constant.
Interest Rate: The higher the interest rate, the higher will be your individual EMI payout as well as the total interest payable on your loan.
Tenure: When a longer tenure is opted for, individual EMI payments will decrease as compared to a shorter tenure for the same loan. But a longer tenure also results in higher total interest payable over the loan tenure.
It is important to understand how banks work out the EMI so that you would find it easier to evaluate various loan options.
So how does the bank arrive at the future value of a loan & interest to be repaid at future dates?
The answer is Time value of money. The theory of time value of money says that a rupee receivable today is more valuable than a rupee receivable at a future date. This is because the rupee received today can be invested to earn interest.
For instance: Rs.100/- receivable today can be invested at, say, 7% interest and therefore enables one to earn additional Rs.7/- in a year.
In the earlier years of loan repayment, it is mainly the interest payments that are being made while the principal amount is much less. As the loan matures, and as the principal gradually gets paid, the outstanding loan amount reduces. The interest component thus becomes lower than the principal, and finally minimal.
PAYMENT OPTIONS
FIXED RATE EMI: Fixed rate loans are those which remain same throughout the tenure. This can be best option only when interest rate has reached bottom, from where upward trend is expected.
FLOATING RATE EMI: Floating rates move in tandem with market and RBI measures which are prone to fluctuation depending on the market and economy.
Does my EMI stay constant?
Yes. Though the EMI is an unequal combination of interest rate and principal, it stays constant. Unless…
- If you prepay part of the loan, the amount of your remaining EMIs will not remain the same if you leave the duration of your loan constant.
- In case you have taken a floating rate loan, the EMI will change as the interest rates change. Of course, some have the option of the EMI not changing but the tenure increasing or decreasing.
- You opt for a loan where the EMI keeps increasing over the years. To give an example, let’s say you have a 10-year loan. The EMI stays constant for three years, then rises for the next three years and rises again for the last four years. This will help young individuals who cannot afford a huge EMI at this point but can do so as their earnings rise.
