Managing Finances with EMI: Types, Examples, and Pros & Cons

Summary:

Understanding the equated monthly installment (EMI) is crucial for borrowers and lenders. This fixed monthly payment encompasses both principal and interest, providing financial predictability. Learn about EMI calculations, methods, and their impact on borrowers and lenders in this comprehensive guide.

What is an Equated Monthly Installment (EMI)?

A regular payment made by a borrower to a lender on a specific date each month is known as an equated monthly installment (EMI). This fixed amount covers both interest and principal, ensuring that over a set period, the loan is entirely repaid. Whether it’s a real estate mortgage, auto loan, or student loan, EMIs offer a structured approach to debt settlement.

How an Equated Monthly Installment (EMI) works

EMIs differ from variable payment plans, providing borrowers with a consistent monthly payment. This predictability aids budgeting, offering peace of mind to borrowers. Lenders benefit from a steady income stream. The calculation of EMIs involves two methods: flat-rate and reducing-balance.

Equated Monthly Installment (EMI) formula

The EMI flat-rate formula combines the principal loan amount and interest, dividing by the total number of periods multiplied by months. The reducing-balance method, often more favorable to borrowers, uses the formula: EMI = P * [( r * (1 + r)^n)) / ((1 + r)^n – 1)].

Example of Equated Monthly Installment (EMI)

Let’s consider a personal loan example to illustrate how EMI works. Suppose a borrower takes out a personal loan of \$10,000 with an annual interest rate of 6%, and the loan term is 2 years.

Calculation using Flat-Rate Method

Using the flat-rate method, the monthly interest rate would be (6% / 12) = 0.005. The total interest paid over the loan term is (\$10,000 * 0.005 * 24) = \$1,200. Therefore, the total repayment amount is (\$10,000 + \$1,200) = \$11,200. Monthly EMI using the flat-rate method is (\$11,200 / 24) = \$466.67.

Calculation using Reducing-Balance Method

Now, using the reducing-balance method, the monthly interest rate is the same (6% / 12) = 0.005. However, the calculation is more dynamic. The first month’s interest is (\$10,000 * 0.005) = \$50. After the first payment, the outstanding balance reduces to (\$10,000 – \$466.67) = \$9,533.33.

For the second month, the interest is now \$9,533.33 * 0.005 = \$47.67. This process repeats each month, with the outstanding balance decreasing, resulting in lower interest payments over time.

The total interest paid using the reducing-balance method is approximately \$120. The total repayment amount is (\$10,000 + \$120) = \$10,120. Monthly EMI using the reducing-balance method is (\$10,120 / 24) = \$421.67.

Practical Application of Equated Monthly Installment (EMI)

EMI finds widespread use in various financial contexts, and a practical example involving a home mortgage can illustrate its application effectively.

Home Mortgage Example

Consider a scenario where an individual takes out a home mortgage of \$200,000 with an annual interest rate of 4.5% and a loan term of 30 years.

Calculation Using Reducing-Balance Method

Using the reducing-balance method, the monthly interest rate is 4.5% / 12 = 0.00375. The first month’s interest is (\$200,000 * 0.00375) = \$750. After the first payment, the outstanding balance is reduced to \$200,000 (EMI). The next month’s interest is calculated based on this reduced balance.

This process repeats each month, with the EMI remaining constant but the interest component decreasing over time as the outstanding balance reduces. This method ensures that borrowers pay less interest overall compared to a flat-rate method.

Impact on Borrowers

The practical benefit for borrowers is the predictability and stability that EMI provides. Knowing the exact amount they need to pay each month facilitates budgeting and financial planning. Additionally, for long-term loans like mortgages, the reducing-balance method can result in significant interest savings compared to flat-rate alternatives.

Impact on Lenders

From the lender’s perspective, EMI ensures a consistent and predictable income stream. This stability allows lenders to manage their financial portfolios more efficiently and plan for future lending activities.

Weigh the risks and benefits

Here is a list of the benefits and drawbacks to consider.

Pros
• Predictable monthly payments
• Structured debt repayment
• Peace of mind for borrowers
Cons
• May result in higher overall interest payments (flat-rate method)
• Reduced flexibility compared to variable payment plans

What does EMI stand for?

In the finance world, EMI stands for equated monthly installment. It refers to periodic payments made to settle an outstanding loan within a stipulated time frame.

How is EMI calculated?

EMI can be calculated using two methods: the flat-rate method and the reducing-balance method. Both consider the loan principal, interest rate, and loan term in their calculations.

How is the EMI deducted from a credit card?

Your available credit limit decreases when you make a purchase using an EMI option on a credit card. EMI on credit cards works similarly to a home loan or personal loan, gradually reducing debt over time.