Last updated on November 24th, 2023 at 12:39 pm
If you borrow loans regularly, the term ‘EMI’ may be familiar to you. An Equated monthly installment plan helps you to know the amount you need to pay per month to offset a loan. Also, it helps to make your personal budgeting process easier. This is because you know the exact amount you need to put aside every month to pay off your loan. Here’s an extensive look at what EMI means and everything you need to know about it.
What is EMI?
Equated monthly installment (EMI) is a specific amount of money a borrower pays to a lender on a monthly basis. Usually, EMI includes both the loan principal and interest amounts. The borrower pays this sum every month in order to offset the loan at the end of the loan tenor.
Basically, EMI allows you to have peace of mind since you will have an idea of the amount you need to pay beforehand. This is very important especially for those obtaining loans as a salary earner.
How does Equated monthly installment (EMI) work?
EMIs are different from variable payment plans. In Variable payment plans, the borrower can remit higher amounts if he or she decides to. However, in Equated monthly investment plans, borrowers can only pay a fixed amount every month. EMI gives a borrower insight into how payments can be spread equally across the loan tenor. Additionally, it helps lenders to look forward to a regular stream of income from the loan interest.
What is the formula for calculating EMI?
Basically, there are two methods used for calculating EMI. They include:
1. The flat-rate formula
You can calculate the flat rate by adding the principal loan and the loan interest. Thereafter, divide the result by the number of months multiplied by the number of periods. Under this method, the interest levy is always on the total loan amount irrespective of the principal amount you pay. The flat rate formula is:
EMI = (Principal + Interest)/Number of months * number of periods
2. Reducing-balance formula
The reducing balance favours the borrower more because it lowers the overall interest payment. Under this method, the interest levy is always on the remaining balance of the loan after you pay a specific amount of principal. Therefore, your loan interest keeps reducing every month. The formula for calculating reducing balance is:
EMI = P * [( r * (1 + r)^n)) / ((1 + r)^n – 1)]
Here, P is the Principal amount you borrowed, r is your Periodic monthly interest rate and n is your Total number of monthly payments.
Basically, both methods take into consideration the loan principal, interest rate, and the terms of the loan. Calculating EMI somewhat works like a loan calculator.
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What are the factors affecting EMI?
Your equated monthly investment depends on some factors. They include:
1. The loan amount
The loan amount, also known as the principal amount, is the biggest factor of your EMI. It is the total amount of money you borrow. The bigger your loan amount, the bigger your EMI.
2. The interest rate
Your loan interest rate is another determinant of your EMI. Your EMI is directly proportional to your loan interest rate. Basically, your interest rate depends on factors like your income, credit history as well as your repayment capacity.
3. The loan tenor
Your loan tenor is the number of years you are given to repay the loan. The longer your loan tenor, the lower your EMI, and a shorter tenor results in a higher EMI. However, a longer loan tenure means a higher interest rate.
These three factors help you to determine the amount of your Equated monthly installment.
The importance of Equated monthly installment cannot be underestimated. It gives you a fixed figure that will help you offset your loan at the end of the loan tenor. This makes the loan repayment method seamless. Also, you will be able to make an accurate financial budget since your loan repayment amount is fixed.
For a lender, it gives you a fixed stream of income to look forward to every month. Without a doubt, the EMI plan is helpful.
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