EMI and its Calculation

WHAT IS EMI ?

When we talk about loans, the most important word associated with it is EMI.

“EMI” stands for Equated monthly installments which is a fixed payment made by a borrower to a lender on a specified date of each month.

These installments are used to pay off both interest and principal each month so that over a specified number of years, the loan is paid off in full. Principal amount is paid back on the total loan amount availed and interest amount is additional to it paid as the cost to the lender for availing the benefits of loan.
Initially, the interest amount is higher than the principal , as we progress along the loan tenure, the portion of interest repayment reduces and contribution towards the principal repayment increases.

FACTORS AFFECTING EMI

The 3 major factors which affect the EMI are –

  • LOAN AMOUNT – This stands for the total amount that has been borrowed the individual.
  • INTEREST RATE – This stands for the rate at which the interest is charged on the amount borrowed . Lenders calculate the interest based on several factors like income, repayment capacity , credit history etc.
  • LOAN TENURE – This stands for the agreed loan repayment time-frame between the borrower and the lender.

HOW TO CALCULATE EMI ?

EMIs are either calculated on a flat or a reducing balance interest rate.

  • FLAT INTEREST RATE METHOD

Under this, interest is calculated on the initial loan amount that you availed and this is applicable for throughout the loan tenure.

The EMI flat-rate formula is calculated by adding together the principal loan amount and the interest on the principal and dividing the result by the number of periods multiplied by the number of months. The formula is :

EMI = (Principal + Interest)/Period in Months

  • REDUCING BALANCE INTEREST RATE METHOD – 

Under this, interest is calculated on the remaining or outstanding balance of the loan amount initially availed. Hence, the interest is different for different months.

The formula used is –

EMI = [P x R x (1+R)^N]/[{(1+R)^N}-1]

Where,

P = Principal loan amount

R= Rate of interest

N = Tenure of loan in months

The EMI payments are directly proportional to loan amount and interest rates and are inversely proportional to the tenure of loan.

Among the two , the reducing balance method is much more economical than the flat rate method since the principal amount already paid gets deducted for the calculation on interest rate of the subsequent period. Hence, the interest is charged on the new balance.

 

Thus, in simple words an EMI is the fixed amount of money that has to be paid regularly to the lender for the repayment of the loan & form an important part of the loan.

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