Loans are an integral part of our lives today. We take loans for a specific purpose – be it for buying a home, a car, or sending kids abroad for education – loans help us achieve some very important life goals. That said, when we talk about loans, the word “EMI,’ eventually crops up because the amount we borrow has to be returned to the lender with interest.
Let’s understand EMI meaning and how EMI works.
What Is an Equated Monthly Instalment (EMI)?
An equated monthly instalment (EMI) is a payment amount made by a borrower to a lender at a specified date each calendar month.
What Factors Affect EMI?
The factors affecting an EMI are as follows:
- Principal borrowed: This is the total loan amount borrowed by the individual.
- Rate of interest: This is the interest rate charged on the borrowed amount.
- Tenure of the loan: This is the loan repayment timeframe agreed between the borrower and the lender.
- Fixed or floating type of loan: If the interest rate is floating, the ‘Rest’ component affects the EMI.
Note: In a fixed type of loan, the EMI amount remains the same throughout the loan tenure. But, in the floating type, the EMI amount may fluctuate as and when the interest rate changes.
How an EMI (Equated Monthly Instalment) Works?
There are two ways of calculating the EMI. They are:
- Flat Rate Method
- Reducing Balance Method
In this method, the principal loan amount and the interest on the principal are added, the sum is then divided by the loan tenure, then multiplied by the number of months in a year.
Example of Flat Rate EMI
Assume you have a home loan of ₹10, 00,000, which is the principal loan amount, at an interest rate of 8% for 10 years. Your EMI using the flat-rate method is calculated as follows:
(₹10, 00,000 + (₹10, 00,000 x 10 x 0.08)) / (10 x 12)
The EMI amount is ₹15,000
The formula to calculate EMI using the reducing balance method is as follows:
(P x I) x ((1 + r)n)/ (t x ((1 + r)n)- 1)
P is the principal amount borrowed, I is the interest rate (annual), r is the periodic monthly interest rate, n is the total number of monthly payments, and t is the number of months in a year.
Example of Reducing Balance EMI
Let’s keep the same example for calculating the EMI using the reducing balance method.
((₹10, 00,000 x (0.08)) x (1 + (0.08 / 12)) 120) / (12 x (1 + (0.08/12)) 120 – 1).
The EMI amount is ₹12,133,
Note: The EMI amount in reducing balance is lower than in the flat rate method. In the EMI flat rate calculation, the principal loan amount is constant throughout the loan tenure. On the other hand, in the reducing balance method, the EMI is calculated on the monthly reduced principal. This suggests that reducing balance may be a more cost-friendly option for borrowers.