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What is an Equated Monthly Instalment (EMI)?

Published On Feb/06/2024

EMIs are vital in financing a variety of purchases, from a smartphone to an entire property. Understanding their significance is crucial since they enable clients to make large-ticket purchases easily. Surprisingly, even though financial institutions have widely supported it for many years, many consumers are still ignorant of the EMI payment option. This post aims to shed light on what EMI means, ensuring readers grasp their importance and advantages.

What is an EMI?

The EMI full form stands for Equated Monthly Instalment. It is the fixed monthly amount a borrower must pay toward a loan. Each monthly EMI comprises payments toward the loan principal and interest accrued on the loan amount. In the early stages of the loan term, the EMI is predominantly assigned to cover interest. Still, as the loan matures, the portion of the EMI allocated to principal payments steadily increases, lowering the interest component over time.

How Does an EMI Work?

So how does EMI work? Unlike variable payment plans, which allow borrowers to pay various amounts, EMIs have a set structure. Borrowers who participate in EMI schemes often make a single set monthly payment. Borrowers benefit from this arrangement since they have transparency regarding their monthly loan commitment, allowing for better personal financial planning.

EMIs, on the other hand, benefit lenders. The continuous and predictable structure of EMI payments provides them with a consistent income stream, mostly through the interest levied on the loan amount.

Components of EMI

EMI consists of two independent components: interest and principal. In the early years of the loan term, the majority of the EMI is used to cover the interest, with contributions to the principal being relatively minimal. However, as the payback period passes, a significant percentage of the EMI is allocated toward repaying the principal, progressively lowering the outstanding loan amount.

EMI Formula & How is EMI Calculated?

The Equated Monthly Instalment is calculated using the EMI flat-rate formula, which combines the principal loan amount with the interest on the principal. This total is then divided by the product of the number of periods and months.

Also Read - What is Principal Amount in Home Loan – Important Things to Know

The EMI reducing-balance approach, on the other hand, is determined using the following formula:

EMI = P * [( r * (1 + r)^n)) / ((1 + r)^n - 1)]

where:

P = Principal amount borrowed

r = Periodic monthly interest rate

n = Total number of monthly payments

EMI can be calculated using two distinct methods, such as:

The Flat Rate Method

The flat rate technique calculates the interest charge based on your initial principal amount as the loan is gradually repaid. The EMI will be calculated by summing the total loan principal and interest to be paid and dividing the total by the number of EMI payments equal to the loan period.

This method is frequently utilized for car loans and personal loans. On the other hand, borrowers tend to gain less from this arrangement because interest payments should cover the whole principal amount over the loan's term. As a result, the flat rate technique has a greater effective interest rate than the reducing-balance strategy.

The Reducing Balance Method

Instead of the above method, the declining balance methodology calculates interest payments depending on the remaining outstanding principal. As a result, the interest with the primary components of each EMI fluctuates. At the beginning of a loan period, interest payments make up a more significant component of an EMI, reflecting a larger proportion of the outstanding loan amount. However, when you repay the loan over time, your interest amount lowers, allowing a more significant portion of the EMI payments to be devoted to principal repayments. This method is widely employed for various financial products, including credit cards, house mortgages, and overdraft services.

Factors Affecting EMIs

The EMI meaning is impacted by three key factors: loan amount, interest rate, and loan tenure. Let's take a closer look at each of these factors:

1. Loan amount: The loan amount is the total amount borrowed by an individual. When choosing a loan that allows for an advance down payment, it is advantageous to pay as much as you can afford beforehand and then arrange a loan for the remainder. You may successfully cut the interest amount and perhaps save on the overall cost of the loan by doing so.

2. Interest rate: The interest rate is the proportion at which interest is charged on borrowed funds. It is a crucial determinant affecting the EMI. For the same loan amount, different lenders may offer different interest rates. As a result, evaluating loan offers from several lenders and negotiating with them to acquire the best feasible interest rate is essential, assuring a favorable agreement with reduced EMI payments.

3. Tenure of the loan: This refers to the time frame for the borrowed debt to be returned. The loan term is pre-determined by the borrower and the lender. Remembering that a longer loan term means larger interest payments over time is vital. An extremely short loan term, on the other hand, might result in a greater burden of EMI payments. As a result, before concluding a loan, it is critical to strike the correct balance between loan tenure and EMI amount, ensuring that it matches your financial capabilities and aspirations.

Types of EMI Loans

EMIs can be used to repay various types of loans, including personal loan, home loans, car loans, and more. Now, let's explore each of these loan types in detail:

Personal Loan

A personal loan is an unsecured type of borrowing that is meant for short-term needs such as family vacations, home upgrades, medical crises, and other similar situations. Unlike secured loans such as vehicle or house loans, personal loans do not require collateral. Due to the lack of collateral, they are often issued at higher interest rates. You may use the Personal Loan EMI calculator to calculate the EMI on a personal loan and locate the best lending deal.

Home Loan

A home loan is obtained in order to purchase a home. Because these loans are secured, they have lower interest rates than personal loans. Home loans often have payback terms ranging from 10 to 30 years. You should examine your EMI responsibilities before starting with your loan application. A home loan EMI calculator can help you quickly calculate your EMI.

Car Loan

A car loan is a secured loan made to fund the purchase of an automobile, with the car itself acting as security. This implies that if the borrower fails to repay the loan, the lender has the right to take the vehicle. An initial down payment of a fraction of the entire cost is required to purchase an automobile. The remainder can then be taken as a loan from a bank and repaid through EMIs.

Advantages of EMIs

Apart from easing loan repayment in manageable instalments, EMIs have various other benefits, including:

  • Enabling the purchase of high-value things that would otherwise be financially difficult.

  • Having set EMI payments allows you better monthly budget planning and financial security.

  • Allowing borrowers to choose the loan term that best meets their financial needs and aspirations.

  • Helping to improve one's credit score if EMI payments are paid on time and consistently, strengthening creditworthiness for future financial pursuits.

Both EMI in arrears and in advance are valid loan repayment choices, and the choice is dependent on one’s financial situation. Choosing EMI in advance may be appropriate to make an advance EMI payment with the down payment at loan disbursement. If you do not have sufficient finances at the time of loan disbursement, EMI in arrears is a preferable alternative.

You may use an online loan EMI calculator to calculate the entire cost of your loan for both EMI in advance and arrears. This tool will assist you in comparing your alternatives and making an informed selection depending on your financial constraints.

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