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In earlier units, while discussing different types of loans, we have come across the term EMI several times. Let us now understand the concept of EMI and how they are calculated.
What is an EMI?
The Equated Monthly Installment, or the EMI, is the amount of money paid by borrowers, each calendar month, to the lender, for clearing their outstanding loan.Generally, EMI payments are made every month on a fixed date for the entire tenure of the loan.
How is an EMI Paid?
When the loan starts, the interest component is very large, and the principal component is very small.
Every month, the interest component becomes lower than the previous month, and the principal component becomes higher than the previous month. As the loan matures, and as the principal gets paid, the outstanding loan amount reduces.The EMI amount is a fixed amount each month, except in the following cases:
1. When the borrower prepays a part of the loan, the lump-sum amount prepaid gets adjusted against the outstanding principal balance,thereby reducing the EMI. The borrower in this case also has an option of maintaining the EMI while increasing the loan tenure.
2. If the borrower has opted for a floating rate loan, fluctuations in home loan interest rates during the loan tenure will alter the EMI.
How is an EMI calculated?
The basic components of an EMI are the principal and the interest payment.However, different lenders may use different computation methods for the EMI. Some of these include -
i. 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.
ii. 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.
iii. 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.
Which Factors Can Affect Your EMI?
The following factors can affect the amount of your EMI payments -
1. Principal amount – The actual amount borrowed from the lender.
2. Rate of interest – The rate at which the amount is being borrowed from the lender. Higher the interest rate, higher will be the EMI amount.
3. Tenure of the loan – This is the duration for which the loan has been taken. With a longer tenure, borrowers intend to repay their obligation slower; hence the EMI would be low and vice versa.
4. Method of computation – How the EMI is computed depends upon the method used by the home loan provider, either daily, monthly or on an annual reducing basis.