What is EMI and how is it calculated

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EMIs are Equated Monthly Installments that form a part of the repayment of the loan that you have availed. It is a fixed amount of money that you need to pay to your bank or financial institution every month as repayment towards the loan you have taken until your loan is fully repaid. EMIs mainly consist of two parts, namely the principal amount and the interest component. The interest is charged on the principal amount, which is then spread across each month of the loan tenure.

How an Equated Monthly Installment (EMI) Works:

EMIs differ from variable payment plans, in which the borrower can pay higher amounts at his or her discretion. In EMI plans, borrowers are usually only allowed one fixed payment amount each month.

The benefit of an EMI for borrowers is that they know how much money they will need to pay toward their loan each month, which can make personal budgeting easier. The benefit to lenders is that they can count on a steady, predictable income stream from the loan interest.

How are Loan EMIs Calculated?

Loan amount, tenure and interest rate are the three key parameters of a loan and these vary in the case of different loan providers. EMI applicable to a loan varies according to all these three parameters. Therefore, before choosing a particular loan, it is very important to have an understanding of these three parameters and how they relate to the loan EMI. However, loan EMI s can be calculated in two ways: the flat-rate method or the reducing-balance method.

Flat rate method:

A Flat rate of interest means the amount of interest paid is fixed. In this method, the amount of interest is calculated on the original loan amount throughout its tenure, thus interest remains constant and does not reduce as the principal amount decreases with your monthly EMI. This method is particularly used to calculate the interest payable for personal loans and vehicle loans.

Interest Payable per Installment = (Original Loan Amount * No. of Years * Interest Rate p.a.) / Number of Installments. 

Take an example of a five-year loan with a principal amount of Rs. 100,000 at a flat interest rate of 10%.

Your annual interest is always calculated as 10% of 100,000. Thus, your annual interest payment is fixed at Rs. 10,000. Total interest over the five-year period would become Rs. 50,000.

Total amount paid for the loan duration = 100,000+50,000 = 150,000

Annual installment (Total amount/ Number of years) = Rs. 30,000

Monthly EMI = Rs. 2,500

Reducing Balance Method:

In the reducing balance method, the interest to be paid is revised every month on the outstanding loan amount. In this method, the EMI includes interest payable for the outstanding loan in addition to the principal repayment. Now, since the principal amount reduces with every EMI payment, the amount of interest payable on it also reduces. Thus, on subsequent EMI payments, the amount towards principal repayment increases. This method is particularly used to calculate the interest payable for housing, mortgage, property loans, overdraft facilities, and credit cards.

The formula to calculate EMI using the reducing balance method would be:

EMI = [P x R x (1+R)^N]/[{(1+R)^N}-1]

Here P is the Principal Loan Amount, R is the monthly rate of interest, and N is the loan duration in months.

So, for the above example, the calculation would be:

EMI = [200000 x 12/(100 * 12) x (1.01)^24] / [{{1.01)^24}-1]

       = 2000 x 1.2697 / 0.2697

       = 9415.65

Here, we can clearly compare that EMIs under the reducing balance method are generally lower than those in the flat rate interest method. The interest component in the reducing balance method would also keep reducing every month, thereby saving costs on the loan for you. Personal loan EMI calculators generally use the reducing balance method, whereas car loan EMI calculators generally use the flat rate interest method.

Conclusion:

The thing to understand is that banks offer low flat interest rates rather than reducing balance rates. But, a cheaper rate may not necessarily be better. If a bank advertises an 8% flat rate while another bank advertises a 12% reducing rate, the reducing rate is actually cheaper.

The best way of comparing is by converting everything into the equivalent rates and comparing equivalent monthly installments (EMI) keeping tenure fixed.

Make use of these free online EMI calculators to know how much you need to pay each month, so you can plan your finances accordingly. Don’t forget, at the end of the day, loans are liabilities, and it is in your best interest to calculate the EMIs and manage your budget accordingly.