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What does the calculation of Equated Monthly Installment (EMI) entail, and why is it significant?
By Team Shepays
2 days ago
An Equated Monthly Instalment, mostly known as an EMI, is a payment made by a borrower to the lender while loan repayment. This payment is generally constant or fixed and is made on a pre decided date every consecutive month until the loan is repaid in its entirety.
EMI consists of both the interest and the principal amount borrowed in the first place.
Here are a few terms that are commonly used while discussing loans, before you understand more about what an EMI is.
The total sum of money which is borrowed is called the principal.
The cost borne to borrow money is known as interest, which is the amount paid for availing a loan.
The tenure is the total duration for which the loan is taken. It may range from a few days or months to a few years, depending upon the type of loan availed.
No-cost EMI and the borrower
In most of the cases, EMIs are paid with an interest. It is the interest that allows the financial institutions to gain money on the amount they lend.
However, in some situations, payment of interest is not needed. These loans are bifurcated into no-cost EMIs. These types of loans are offered by retailers and e-commerce marketplaces on consumer durables and electronics.
How does an Equated Monthly Instalment (EMI) operate?
EMIs are not similar to variable payment plans. In the case of EMIs, the borrower has to pay a certain amount every consecutive month. However, in the case of variable payments, tweaks can be made to the amounts paid by the borrower. Most borrowers find the former useful because with the exact EMI payment in sight, they can construct their financial plans.
Moreover, lenders are assured that they have a reliable source for a fixed amount of income every month through the interest payment.
Principal and interest rate calculation
We may use the following formula, to calculate the amount that you are paying against the principal every month.
E = P x [r x (1+r) ^ n] / [(1+r) ^ n] - 1
Where in,
E is EMI
P is principal
r is the rate of interest
n is the loan tenure
Once you know your EMI, you can calculate the interest component using the formula-
Interest = P x r
P is the remaining principal
r is the interest rate periodically
Further calculation for the principal component can be made by subtracting the interest from the EMI.
Calculation for EMI
The Flat Rate Method
Flat Rate Method is majorly used to calculate and deduce EMI for personal loans but sometimes auto loans as well. The interest is computed on the principal, then summed to the entire amount. Furthermore, this sum is divided by the number of instalments to be paid during the duration of the loan.
Since the interest must shield the entire principal amount, the effective interest rate is way more than the Reducing Balance Method. This puts the borrowers at a major disadvantage.
The Method in use.
In case you are supposed to calculate EMI with this method, you need to sum the principal to the interest and divide the final amount by the number of periods multiplied with the number of months.
INR [30,00,000 + (30,00,000 x 20 x 0.07)] / (20 x 12) = INR 30,000
So, Mr. Aiyer will have to pay an EMI of INR 30,000 per month, wherein the principal and the interest are same every consecutive month.
Reducing Balance Method
The Reducing Balance Method is generally applicable to home mortgages and credit cards. In this method, interest is calculated based on the outstanding principal amount and not on the entirety of the principal.
Therefore, every month, a borrower pays a different amount of interest and principal instalment to cover up the loan amount. In this scenario, the interest segment of the EMI is greater in the beginning stages of loan repayment.
With subsequent loan repayment over the time, the interest segment reduces and paves the way for larger allocation to the principal amount. You can make use of an online EMI calculator to deduce the instalment amount and make an appropriate decision.
Reducing Balance Method in use.
To calculate the EMI with this method, the formula is-
INR 30,00,000 x [0.0058 x (1 + 0.0058) ^240] /[(1+0.0058) ^120 - 1] = INR 18,765
As per this method, Mr. Aiyer has to pay only INR 18,765 per month.
In this scenario, the principal and the interest segments of the EMI vary every month. It happens because interest charge is calculated on the outstanding principal and not on the entire principal amount.
Therefore, this method serves to be more cost-effective to the borrower group.