Nowadays, loans are available for everything that we need and help us fulfill our diverse needs. Be it a home loan, car loan, education loan, or even a wedding loan! But the first thing we think about before applying for a loan is its affordability. Any loan or the amount that you borrow has to be repaid over the time along with interest and some amount of fees. Hence, it’s important to work out the cost of your loan before you borrow. In this article, let’s understand how loans work, how the cost of your loan is computed and what are the factors affecting it. Before we talk about anything, it’s essential to understand the most vital component of loans – the EMIs.
What is an EMI?
EMI or Equated Monthly Installment is a fixed sum of money paid by you (borrower) each month on a specific date to the Banks or NBFCs (a lender) until your entire amount of debt is repaid. Basically, how much a loan is going to cost you monthly is technically termed as EMIs. EMI is essentially made up of two components, the principal amount that you borrowed and the interest on that borrowed sum, divided across each month of the loan payment term. Though EMI is a fixed monthly amount, it’s an unequal combination of principal and interest.
Key Factors Affecting the EMI
Principal: It is the sum of money that you borrow from the lender. Principal is an essential factor while determining the cost of your loan as Interest is calculated as a percentage of your principal
Interest Rate: It is the rate at which lender offers you the loan. It’s important to do the basic research on interest rates offered in the market. Getting a competitive rate helps you work out a cost of loan in your benefit.
Tenure of Loan: It is the time period for which you have borrowed. It has a major impact on EMI amount. Monthly installment is lesser for longer tenure loans and vice a versa.
How is the EMI Computed?
Once you have all the information of key factors, you can start calculating the cost of your loan which is calculated in terms of equated monthly installments. Once your calculation is done, if the EMI is more than what you can afford, then you can adjust either by reducing the loan amount or by increasing loan tenure. However, Calculating the EMI amount manually is a wearying process. There are loan EMI calculators available online to make this more efficient, time saving and easy process for you.
Here is the mathematical formula used behind the calculator:
Equated Monthly Installment (EMI) = [P*I*(1+I) ^n]/ [(1+I) ^n-1]
P = Principal / Loan Amount
I = Interest Rate per Month (Please remember, EMI is calculated on monthly interest rate basis. divide the annual interest rate with the total number of months in year (12) to get the monthly interest rate.)
N = Number of monthly Installments.
While, this is a basic formula; lenders even include processing fees that they charge for the loan while calculating the equated monthly installment.
We already know that EMI is split into unequal combination of principal and interest. During the initial years of loan payment, interest component paid is more while the principal amount is less. In the later years, principal component of the EMI is higher.
Loan amortization table will give an idea on how this works, and how interest cost goes down gradually over time by giving a break up of EMI for the loan tenure chosen.
Loan Amortization Table
Let’s say you took a home loan of Rs 10 lakhs at an interest rate of 9.5% p.a. for 10 years. Here’s how your loan will be paid off over the course of those 10 years:
|Month and Year||Principal Paid(A)||Interest Paid(B)||Total Payment (A+B)||Outstanding Loan Balance|
|Rs. 10,086||Rs. 15,794||Rs. 25,880||Rs. 9,89,914|
|2017||Rs. 63,973||Rs. 91,304||Rs. 1,55,277||Rs. 9,25,941|
|2018||Rs. 70,322||Rs. 84,955||Rs. 1,55,277||Rs. 8,55,619|
|2019||Rs. 77,302||Rs. 77,975||Rs. 1,55,277||Rs. 7,78,317|
|2020||Rs. 84,974||Rs, 70,303||Rs. 1,55,277||Rs. 6,93,343|
|2021||Rs. 93,407||Rs. 61,870||Rs. 1,55,277||Rs. 5,99,936|
|2022||Rs. 1,02,678||Rs. 52,600||Rs. 1,55,277||Rs. 4,97,259|
|2023||Rs. 1,12,868||Rs. 42,409||Rs. 1,55,277||Rs. 3,84,391|
|2024||Rs. 1,24,070||Rs. 31,207||Rs. 1,55,277||Rs. 2,60,321|
|2025||Rs. 1,36,384||Rs. 18,894||Rs. 1,55,277||Rs. 1,23,937|
|2026||Rs. 1,23,937||Rs. 5,460||Rs. 1,29,298||Rs 0|
You will notice that in the initial years, the interest amount forms the major portion of your EMI. It is only later that the principal amount accounts for the bigger chunk. As a result, it is often advised to switch your home loan in the early years for maximum savings!
Below are some instances wherein your EMI can change during the repayment term of your loan:
1. Partial repayment of loan: In case you make a prepayment of your loan, then the outstanding loan balance will change (principal amount will go down because of the prepayment). Hence, the EMI amount will be reduced. You can also opt for reducing the loan tenure instead of changing the EMI.
2. Change in rate of interest: If you have floating rate of interest, then your rate will change as and when RBI announces repo cuts. Here also, you can ask your lender to change the tenure instead of changing amount of EMI while resetting the interest rate.
3. Flexible EMIs: If you have chosen flexible EMIs, you would have the option of step-up or step- down EMIs. In the former, your EMI amount will increase after certain intervals of time to keep pace with you income growth. Whereas in the case of step-down EMI, your monthly amount will reduce over time. In this case your initial EMIs will be high but later ones will be easy on the pocket.
Now that you have understood all about loan EMIs it’s always important to work out the cost of your loan before you apply to have the clear idea on its affordability. Make use of the online tools and calculate the EMI before you apply for loan to avoid stretching beyond your payment capacity.