EMI known as Equated Monthly Instalment, is a very frequently heard term, in day to day conversation, especially conversation in context of repayment of loan. Whether a person’s intent is to buy a phone or a car, understanding EMI, and how it works plus, being aware of its risks and benefits is important for making a wise decision, while taking out a loan.
In this blog, we will discuss everything related to EMI, what it is, how it is calculated and it’s associated risks. We will also discuss how EMI is calculated.
What is EMI
EMI or Equated Monthly Instalment, is a regular payment, made by the borrower to the lender in order to repay the borrowed loan amount. This certain amount includes both the principal amount and the interest required to pay. To make it easier to understand we will illustrate a example,
Assume that a person wants to buy Apple iPhone 15, which currently is being sold at 65,999 INR,and HDFC bank is offering 6 month period EMI payment of 16% per annum, The borrower will need to pay 11,519 INR per month for six month that will incur 3,113 INR of interest payment, aggregating total of 69,113 INR, this is the total amount at the end of the tenure, he would need to pay.(We will elaborate further in EMI calculation formula)
EMI is provided for all kinds of loans, from common appliances like refrigerators to different types of home loans. Originally this concept of EMI was introduced to make repayment simple, so the borrower can pay back the loan in small amounts without worrying about complexities of repayment structure. But often not being aware of risks associated with it, borrowers make unwise decisions and take inappropriate EMI.
Types of EMI
Generally there are two types of EMI (Equated Monthly Installment) loans in India: EMI in advance and EMI in arrears
EMI in Advance
EMI in advance requires paying the first installment upfront before receiving the loan. This first installment covers only principal, not interest. Bank deducts this amount and fees from the total loan, then disburses remaining. From the second installment onward, the borrower pays principal and interest monthly. It reduces outstanding principal but requires larger upfront payment and increases total interest paid.
EMI in Arrears
This option is also called the regular EMI or standard EMI. No installment is paid upfront when taking a loan. Bank disburses full loan amount after deducting processing fees. The monthly installments consist of principal and interest. Suitable for those without large savings for down payment. Less upfront payment compared to EMI in advance. Total interest paid is lower over loan tenure. Easier loan management with only regular monthly installments.
EMI Components
The components of an Equated Monthly Installment (EMI) include:
Principal: This is the original amount the borrower intended to take loan for, in iPhone example it was 65,999 INR.
Interest: This is the amount paid to the lender for borrowing the money. At the beginning of the repayment tenure, the interest component is much higher, but as the EMI payments go by, the interest component reduces while the principal component makes up for the larger part of the Equated Monthly Installment , in iPhone example interest rate was 16% PA.
How Is an EMI Calculated?
EMI is calculated by this formula:
A= P*(r(1+r)^n)/((1+r)^n-1)
In which,
^= power raise to, means for eg, 2^3=2*2*2=8
P = Principal loan amount, amount for which loan is taken.
A= total payment per month that need to be made
N = Loan tenure in months, Total duration of loan repayment schedule.
R = Monthly interest rate, Interest rate charged, The rate of interest (R) on your loan is calculated per month. R= Interest rate per annum/12/100
So in the iPhone example, with principal amount of 65,9999 INR, interest rate 16% pa, i.e R= 16/12/100= 0.013 and n=6 (number of payment in tenure, i.e, 6 month emi) if you plug all the values you get total payment per month to be 11,505.71 INR
To make calculation less tedious, use of online EMI calculators can be opted, common interest rates employed by banks can be determined by looking at what is MCLR rate ( This is basically the minimum interest rate a bank can charge for loan).
Factors Affecting EMI
There are various factors that can actually influence EMI, here are some main factors that determine the EMI:
Principal: The initial amount for which loan was taken, typically higher principal amount means higher EMI, vice versa.
The interest rate: The interest rate determines the EMI calculation, the initial interest rate that loan was contracted in affects the EMI amount, higher interest rate results in higher per month installment payment.
Tenure: Tenure is the time period for which loan would be paid back, the higher the tenure is, the lower is monthly installment need to be paid.
Credit score: Credit score determines creditworthiness of a borrower, the better the score is the lower interest rate EMI loan will be offered. It is a 3 digit number ranging from 300 to 850.
How does EMI differ from traditional Loan Payments ?
In India EMI payment differs from traditional loan payments in these key aspects:
Repayment Structure
In the traditional way of loan repayment, the borrower pays back all the money borrowed and interest together in one big amount when the loan period finishes. This method allows you to make your payment at the term’s end.
EMI payment means each month you give the same amount of money that is part loan and part interest until the whole loan is paid in the time given.
Interest Calculation
In a conventional loan, the interest is charged based on the original principal loan amount. The borrower pays a fixed interest rate decided at the start, calculated on the full principal amount.
With EMIs, however, the interest is calculated on the remaining outstanding loan balance that decreases with each monthly payment. As you pay the installments, the interest rate gradually reduces since it applies to a smaller remaining loan amount.
So, in conventional loans, interest is fixed on the original principal, while in EMIs, the interest gets progressively lower as you repay the loan through the monthly installments.
Flexibility
Equated Monthly Installment method of payment offers a more flexible way to make loan payments, as the payments are spread out over the time period, this provides a better way to manage expenses and make calculation of loan and payment easier. This is beneficial for borrowers who want to manage their monthly budget in predictable fashion.
Risk Management
Additionally, EMI payments can also be treated as a strategy to mitigate lender’s risk. The lender instead gets to spread the risk of a default by requiring repayments to be made over an extended period. If the borrower fails to meet the payment obligation, the lender can still claim EMI amounts that got paid.
Risks associated with EMIs
While EMIs make it easier to pay back loans, there are some risks you need to watch out for:
Interest Rates Going Up
With variable interest rate loans, EMI amount can increase if rates rise later, disrupting budget planning. Carefully assess ability to handle potential higher EMIs before opting for such loans.
Charges for Prepaying
Some banks charge a prepayment penalty fee if you want to close the loan before the full term by paying the outstanding amount upfront. Check for such charges to avoid surprise costs when prepaying the loan.
Bad Credit Score
Delaying or missing EMI payments negatively impacts your credit score. A poor score makes securing new loans or credit cards at favorable rates extremely difficult in the future. Timely EMI payments are crucial for maintaining a good credit history.
Conclusion
EMIs have really changed how we pay back loans and different types of mortgage. Instead of having to pay one huge amount, EMIs allow us to pay in smaller, fixed monthly installments. This makes it much more manageable and allows better planning. However, it’s important to understand the different EMI options available and be aware of the possible risks involved.
Whether the purpose of the loan is to buy a car or a new house, choosing the correct Equated Monthly Installment is important. It makes the repayment smooth and helps you achieve your financial goal.
Key things to consider are, how stable is your monthly income, what are current interest rates doing, and how much repayment burden can you realistically handle.
EMIs have definitely made borrowing and debt management easier. But it should be used wisely by selecting the best option for the situation. This way, you can enjoy the benefits of EMIs while avoiding potential pitfalls, setting yourself up for a secure financial future.
