Understanding EMI

In our advisories, we have a number of readers who write in with queries regarding EMIs.

The acronym for Equated Monthly Installment, this is the amount you will have to pay every single month when clearing your loan. It could be a home loan, a personal loan, a vehicle loan, a consumer durable loan or an education loan.

This is the first of a three-part series on explaining what they are, how they are calculated and what you must know to make it work for your benefit.

The EMI combines principal and interest

It is an unequal combination of principal (the actual loan you have taken) and interest rate.

In the earlier years of loan repayment, it is mainly the interest payments that are being made while the principal amount is much less. Towards the end of the repayment tenure, it is more of the principal that is being repaid, not interest.

Loan amount: Rs 1,00,000
Rate of interest: 8.75% per annum
Tenure: 10 calendar years
EMI: Rs 1,254

Let's say the EMI payments start from January 1, 2006.

Financial year	Interest paid	Principal repaid
Jan 2006 - Mar 2006	Rs 2,175	Rs 1,587
Apr 2006 - Mar 2007	Rs 8,349	Rs 6,699
Apr 2007 - Mar 2008	Rs 7,736	Rs 7,312
Apr 2008 - Mar 2009	Rs 7,069	Rs 7,979
Apr 2009 - Mar 2010	Rs 6,343	Rs 8,705
Apr 2010 - Mar 2011	Rs 5,550	Rs 9,498
Apr 2011 - Mar 2012	Rs 4,685	Rs 10,363
Apr 2012 - Mar 2013	Rs 3,742	Rs 11,306
Apr 2013 - Mar 2014	Rs 2,711	Rs 12,337
Apr 2014 - Mar 2015	Rs 1,589	Rs 13,459
Apr 2015 - Dec 2015	Rs 531	Rs 10,755

So, while the EMI remained constant every month, you were paying a higher component of interest when you began repaying your loan and a higher component of principal towards the end.

The EMI stays constant

Though the EMI is an unequal combination of interest rate and principal, it stays constant.

There are a few exceptions though.

i. You prepay part of the loan. In this case, it is obvious that the amount of your remaining EMIs won't remain the same if you leave the duration of your loan constant.

ii. You have taken a floating rate loan where the interest rate keeps changing. In this case, 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.

iii. 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.

What determines the EMI

Four factors go into the determination of EMI.

• The principal amount

This is the actual loan amount taken. Obviously the larger the amount, the greater the EMI.

Rate of interest = 8% per annum
Tenure = 10 years

EMI for a Rs 8,00,000 loan = Rs 9,935
EMI for a Rs 10 lakh (Rs 1 million) loan = Rs 12,419
EMI for a Rs 12 lakh (Rs 1.2 million) loan = Rs 14,903

• The rate of interest

Another obvious one, the higher the interest rate, the higher the EMI.

Loan amount = Rs 10 lakh (Rs 1 million)
Tenure = 10 years

EMI for 8% per annum = Rs 12,419
EMI for 8.5% per annum = Rs 12,701
EMI for 9% per annum = Rs 12,985

• The tenure

The longer you take the loan for, the lesser the EMI. The faster you want to repay it, the higher the EMI.

Rate of interest = 8% per annum
Loan amount = Rs 10 lakh (Rs 1 million)

EMI on a 5-year loan = Rs 20,871
EMI on a 10-year loan = Rs 12,419
EMI on a 15-year loan = Rs 9,736

• How the interest rate is calculated

It could be calculated either on monthly reducing basis or on an annual reducing basis. Monthly reducing basis means that, every month, the principal amount paid will be taken into account when calculating the next month's interest.

Annual reducing basis will take into account the principal amount repaid every year before calculating the remaining principal amount.  

Rate of interest = 8% per annum
Loan amount = Rs 10 lakh (Rs 1 million)
Tenure = 10 years

EMI on an annual reducing basis = Rs 12,419
EMI on a monthly reducing basis = Rs 12,133

This means there is a difference of Rs 34,320 over 10 years. Which means, the more frequently it is computed, the better.

Now that you have understood the basics of EMI, tomorrow we will tell you how exactly the EMI is computed.