What is an EMI?
We have all heard of the term EMI (Equated Monthly Instalment) in relation to loans. In simple terms, an EMI is how much you need to pay to your lender every month in order to fully pay off your loan. It is a fixed amount which has to be paid by the borrower to a lender at a specific date every month towards paying off the loan in full. Each EMI consists of part payment towards both the principal and interest amount.
How is the EMI calculated?
The EMI is calculated on the basis of a mathematical formula which factors in
• Loan amount
• Interest rate
• Loan period
Let’s say you take a loan of Rs 5 lakhs, at 10% for a 5 year period. Based on these 3 factors, the bank will calculate how much you have to pay every month for the next 5 years to fully pay off the loan with interest. This monthly amount is your EMI.
You can calculate your EMI using the formula with a simple calculator. Several banks and lenders offer an EMI calculator on their websites which enable you to see what your EMI payment will be over the repayment period – or basically, how much your loan will cost you every month.
During the initial stages of your loan tenure, most of your EMI goes towards repaying the interest component. During the later stages, the EMI goes predominantly towards repayment of the principal. So if your loan tenure is 10 years, at the midway point of 5 years you would have paid off most of the interest component. The EMIs over the remaining 5 years would mostly be towards paying off the principal amount.
If you have a high loan amount and interest rate, your EMI will go up. However, if you have a long repayment period, it will cause your EMI to go down.
Can the EMI amount change?
Your EMI depends on the kind of plan you have taken. Banks offer two main types of interest plans on loans - Fixed Rate or Floating Rate plans.
Fixed rate: If you opt for a fixed rate plan, your interest rate remains the same throughout the tenure of your loan. Therefore, your EMI amount remains the same every month for the whole the repayment period. This can help with your personal budgeting as you know exactly what your monthly outflow will be over the tenure of the loan.
Floating rate: When you opt for a floating rate plan, the interest rate charged on your loan changes with prevailing market rates. Your EMI will be periodically adjusted in accordance with current interest rates. While this may be of benefit if interest rates fall during the tenure of your loan, it also makes your monthly outflow difficult to predict since it changes with fluctuation in market rates.
If you initially opt for a floating rate plan and decide later that you want to change to a fixed rate plan, many banks will allow you to do so on payment of a conversion fee.