Home The beginner’s guide to EMI and how it is calculated
The beginner's guide to EMI and how it is calculated

The beginner’s guide to EMI and how it is calculated

by Priya

Many of us have, at some point in our lives, wished to purchase something expensive, which has been out of our ability to pay for it all at once.

Perhaps many of us have wondered what it would be like to possess that thing first and consider paying the price later. In principle, EMI allows one to do precisely that. It is a method of payment designed to create a channel for gradual, periodical payment submission while enjoying the benefits of the commodity itself. 

Although it is a fairly common term today, many are still unsure about what EMI entails or how it is calculated in the financial system. In this article, we will attempt to define and simplify the fundamental aspects of EMI.

Definition of EMI:

The acronym EMI stands for Equated Monthly Installment. It refers to a specified amount of money payable by a person to the moneylender on the principal borrowed. The principal sum owed is repaid in installments on a fixed date monthly. 

The repayment of the principal sum will continue until the total amount is paid back, along with all the accumulated interest over the period.

This owed money can be anything from a commodity payment, housing loan, student loan to mortgages. The sum total of the principal amount owed and interest is divided equally over months or years. The amount to be paid every month according to that division is called the Equated Monthly Installment.

Pros and cons of buying things on EMI:

Pros:

Buying capability:

If you have a fixed monthly income, it becomes easier to pay for an expensive commodity in EMIs than in a lump sum.

Manageability:

Since the price becomes distributed between months, it becomes easier to manage the expense with EMIs.

Budget planning:

As the amounts to be paid in an EMI scheme can be calculated easily using online calculating tools like the ones found at sites like Money View, it becomes easy for a person to plan monthly budgets and manage their funds smartly.

No middlemen:

EMI payment ensures that the money transaction occurs directly between the customer and the loaner, thus neutralizing any chance of financial meddling.

Customisable budgeting:

Many banks and other institutions offer EMI schemes that can be tailored according to personal convenience. This lets one choose the amount payable every month or the scheme’s duration freely according to preferences. 

Cons:

Duration of debts:

EMIs are meant to be paid across an extended period, thus opting for an EMI plan means being burdened longer by the debt.

Greater payments:

If a person opts to buy an expensive product on EMI, then that can often mean paying more than the cost price. Every month, along with the principal cost, a certain interest is also applied in most cases. This interest, when added up, will inflate the price of the commodity well above the MRP. In such cases, if paying the money upfront is not an option, one may look for zero-interest EMI plans.

Prepayment may not be an option:

Some may come across a sum of money within the tenure of the EMI scheme and want to be done with the debt. However, it might not be as simple as just paying back the money that one owes, as most EMI plans have an in-built prepayment penalty of about 2-3% of the principal for such people.

Skipped EMIs can be troublesome:

If, due to any unforeseen financial crisis, one is unable to pay the EMI for a month, it may incur severe penalties. If the EMI plan is on a vehicle loan or housing loan, the lender can even confiscate and assume ownership of the property under the mortgage, adding further burden on an unfortunate situation.

Credit score impact:

A skipped EMI can negatively affect a person’s credit score at his or her bank.

Added charges from the banking sector:

When opting for an EMI plan, a person is entrusting the handling of the financial processes to an institution. To ensure smooth execution of the processes, these institutions can charge the customer additional processing fees. 

How is the rate of EMI calculated? 

There are two common methods of calculating EMI. These are as follows:

  • Flat-Rate Method.
  • Reducing-Balance Method.

1 . Flat-Rate Method:

The flat-rate method is a simple way of calculating EMI. The sum total of the principal amount and the accumulated interest is equally divided between the number of months in the payment period, thus giving the EMI amount. 

The formula thus derived can be expressed as EMI = [p + {( i/100×p) × n}] / ( n × 12 )

Where,

p = Principal amount owed

i = Annual rate of interest 

n = number of years

Let us illustrate this with a hypothetical example-

If a person A buys or loans something worth ₹ 20,000 at an interest rate of 10% per annum, and plans to pay it back in 4 years, then the flat-rate EMI to be paid every month by A in INR can be calculated as,

[20,000 + {( 10/100 × 20,000 ) × 4}] / (4×12) = 28,000 / 48

= 583.30

So in order to pay back what is owed, the customer must pay ₹ 583.30 every month for 4 years.

2 . Reducing-Balance Method:

Unlike the flat-rate method, the interest amount to be paid with respect to the owed principal amount changes with time in this reducing-balance method. 

Generally, the bulk of the EMI amount is calculated on the basis of the percentage of the principal. This is how it is at the onset of the payment procedure. 

As time passes and the Equated Monthly Installment gets paid periodically, the entire process becomes more comfortable for the person paying the EMIs. 

The amount being calculated as the payable interest decreases slowly. Now, it is calculated based on the outstanding amount remaining after each periodic payment. 

What happens instead? The portion of the owed principal amount, which is calculated in the EMI, starts to occupy the major part of the total EMI amount.  

The reducing-balance method of EMI uses the following formula:

i = (r × p × n) / (n ×12)

Where, 

i = interest amount for each EMI.

r = rate of interest at which the loan was taken.

p = the portion of the principal amount that remains to be paid.

n= tenure period.

Moving on, let us illustrate the application of this method using the hypothetical situation considered for the flat-rate method.

If person A buys or loans something worth ₹ 20,000 at an annual interest rate of 10%, payable within 4 years, then using the flat-rate formula, the EMI for the first month comes at INR 583.30. 

Now in this ₹ 583.30, the portion belonging to the interest payment is ₹ 166.67. The remaining ₹ 416.63 goes to the payment of the principal amount. 

So the EMI for the next month would be calculated based on a principal amount that is ₹ 416.63 less than the original principal amount of ₹ 20,000. That is, the principal for calculation of the EMI for next month would be ₹ 20,000 – ₹ 416.63 = ₹ 19,583.37.

So the interest for the next month in INR comes to,

i = {(10/100×19,583.37)×4}÷48

  = 163.20.

Thus, as is evident, the amount to be paid as interest gradually decreases over time after each subsequent payment in this reducing-balance method of calculating EMI.

Related Articles: Personal Loan EMI Calculator to Calculate Your Monthly EMI

Conclusion:

As can be inferred from the information provided above, EMI schemes are highly attractive financial plans allowing one to acquire goods not immediately accessible otherwise. However, while opting for an EMI scheme, one should be aware of the risks and conditions entailed and prepare accordingly.

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