Are you looking for a loan to buy your dream home or car? Or maybe you are looking for a loan to pursue further education. Then you might have come across the term EMI when considering loans. But what is EMI? And how is it calculated?
This article seeks to answer these questions and show you how it is calculated, so you can figure it out without an EMI calculator.
Go ahead and read on so you can make an informed choice if you decide to take out a loan.
What is an EMI?
EMI or equated monthly installment is a payment amount the borrower pays to the lender at an agreed-upon date each month until the loan is paid in full.
EMIs are applied on both the interest and principal amounts each month, but the weightage is more towards the interest amount during the initial months of the loan tenure.
EMIs are most commonly used in home, car, and personal loans, where the borrower pays off the bank or financial institution over an agreed-upon tenure.
What are the factors that affect EMI?
Four main factors affect EMI:
- Principal amount: It is the total amount of loan borrowed by someone.
- Interest rate: The rate of interest charged on the borrowed amount.
- Loan Tenure: This is the agreed-upon timeframe within which the borrower will repay the lender.
- Loan type: If the loan has a fixed interest rate, there will be no effect on EMI, but if the interest rate is floating, the EMI may change
What is the loan amortization schedule?
The table that outlines details of a loan and the EMI payments’ breakup is known as the amortization schedule. It denotes how much of the EMI is divided between the principal and interest amounts until you pay off the loan.
This helps you understand the loan’s progress over its tenure and necessary details such as
- EMI amount
- Principal amount
- Each EMI payment interest cost
How is EMI calculated?
There are two methods to calculate EMI:
Flat rate method:
In this method, the principal and the interest amount are added, and the sum is divided by the tenure of the loan multiplied by 12 (for the number of months in a year).
Let’s say you are taking a home loan of Tk. 10,00,000 at 10% for 8 years. Then according to the flat rate method, your EMI would be
[10,00,000 + (10,00,000 x 8 x 0.10)]/ (8 x 12)
Your EMI amount would be Tk 18,750.
Reducing balance method
The formula for calculating EMI using the reducing balance method is as follows:
[ P x R x ( 1+R)^n] / [(1+R)^n-1]
P = principal amount
R = periodic monthly interest rate
n = total number of monthly payments you have to make
Using the same example as above:
[100000 x 0.0083 x (1+0.0083)^96]/ [(1+0.0083)^96 -1]
Your EMI using the reducing balancing method is Tk. 15, 103.28
What are the types of interest rates?
There are two different types of interest rates as follows:
Fixed interest rate
This interest rate stays constant throughout the loan’s tenure, meaning EMI will remain constant. Although fixed interest rates are 1 to 2% higher than the floating ones, you get the benefit of having a clear idea of your payments until repayment.
Floating interest rate
In this type of interest rate, the rate is subject to change depending on market trends. Since it depends on the base rate, it changes along with it. It is best to choose a floating interest rate if your loan is long-term, so you can plan your prepayments and reduce the interest.
N.B. Speak to your bank representatives about floating interest rates as not all banks may want to offer it in their loans.
Can EMI change during the loan tenure?
There are a few factors that may affect your EMI over the tenure of your loan. They are:
Many banks let you prepay a portion of your loan in a lump sum payment ahead of your payment schedule. When you prepay a part of your loan, it decreases the principal amount as well as the amount of interest. This means your EMI will decrease as well.
Floating interest rate
If you have chosen a floating interest rate for your loan, if there are any market interest rate changes, then your EMI will also change.
Some banks offer progressive EMI’s where you pay a fixed EMI for a certain period, and your payment amount increases afterward. This facility is applicable for loans with a lengthy tenure.
EMIs have made it easier for borrowers to make personal budgeting decisions, knowing exactly how much they will need to pay each month. This has also benefitted lenders as they get a regular and reliable monthly payment on their loans.
The use of EMI has increased dramatically throughout the world as more and more people are taking out loans to fulfill their dreams.
Hopefully, this article has removed any confusion you may have had about EMI.