What is EMI
EMI stands for Equated Monthly Installment. It is the fixed monthly amount owed by a borrower to the lender. EMI pays off both the components of the loan amount (interest and the principal).
There are 2 types of EMI options generally available -
i. Flat rate EMI
ii. Reducing balance EMI.
Let's have a look into both types, how they are calculated and which one to choose.
Types of EMI and their calculations -
Flat rate EMI can be calculated directly by taking a percentage rate charged by the lender and dividing it over the period.
For example - Let's assume we have taken a loan of 1,00,000 which is to be paid in 1 year and the rate of interest being charged for it is 5%. Since 5% is being charged, the lender would want all 5% as his profit within the given period. EMI in this case would be (1,00,00 + 1,00,000 * 5%)/12 = 8750/month
Extending the same example, since we are giving the money monthly to the lender, the lender can earn an extra 5% on your paid EMI by giving it again to some other borrower which is a loss for you as you are not rewarded by the money lender is earning. If the required rate of return for the lender is 5 %, we can earn some interest on EMI by saving it monthly and giving a lumpsum amount of 1,05,000 to the lender effectively reducing our cost.
This is addressed by reducing balance EMI calculation method wherein we assume that the lender can make 5% on every EMI we pay and pay our EMI adjusted to the interest earned on EMI. The above tool uses this method to calculate the EMI, by plugging in the loan amount as 1,00,000, interest rate of 5% and duration as 12 we get an EMI of 8560.75/month which is 189.25/month less than the flat rate EMI !!
Next time you get offered, you can use the above tool to check if your EMI aligns with the calculations.You can also have a look into how your loan is amortizing over the period and check the interest part and principal part in your EMI in any month along with how much interest you are paying and the loan amount as a percentage of the total payable amount in the pie chart.