How do EMIs work : Key Factors and tips for effective EMI management
Equated monthly instalments, or EMIs, are fixed payments borrowers make to lenders on a predetermined day every month. These payments cover the loan’s principal and any applicable interest.
The three key elements involved in calculating EMI are the loan amount (principal), the lender’s interest rate, and the loan term, which is the total duration of repayment.
The EMI formula is EMI = P * r * (1 + r) ^n / ((1 + r) ^n – 1), where ‘P’ is the principal, ‘r’ is the monthly interest rate, and ‘n’ is the number of months for the loan duration.
For example, if Mr. ABC takes out a loan of ₹10,00,000 at an 8% annual interest rate for 5 years, his EMI would be approximately ₹20,276 per month using the formula. Most EMIs are calculated using the reducing balance method, where interest is charged each month’s remaining loan balance.
This method is more cost-effective than the flat rate method, which charges interest on the full loan amount throughout the loan term, regardless of the payments made.
Benefits of EMI: Advantages of choosing EMI for loan repayment
EMI cards have become the most favoured credit tool among lower-middle-class borrowers in India, with 43% considering EMI cards as their preferred option.
Additionally, 37% of Indians now take out loans to purchase smartphones and home appliances, a significant rise from just 1% in 2020. Borrowers are also increasingly using loans for home renovation and construction projects.
Here are the benefits of opting for EMIs:
1. Manage Monthly Budget
Perhaps the biggest benefit of EMI is that it helps properly manage monthly budgets. Paying EMI has a fixed schedule, and according to it, one can clearly see one’s future expenses.
2. Purchase High-End Products
EMI allows individuals to make purchases that otherwise become too heavy for their pockets. High-value items, such as homes and cars, can also be bought by people who cannot pay that amount.
3. Flexible Loan Tenure
EMIs enable the borrower to utilise leverage to choose the loan tenure based on repayment capacity. According to their financial position, a borrower can opt for higher EMIs with shorter tenures or lower EMIs with longer tenures.
4. Enhance Credit Score
Regular, on-time EMI payments boost the credit score directly. A healthy credit score helps you get all future loans at a better rate. With every timely payment, the EMI is reflected positively in the credit report, showing the borrower as a responsible user.
5. Special Schemes and Offers on EMI
Paying EMIs can strengthen relationships with financial institutions and retailers. They can offer special EMI schemes during festivals and sales times. These schemes have zero or lower interest costs, making EMI even more attractive for borrowers.
Types of Loans with Emi: Common Loans That Involve EMI
EMI has been extended to all kinds of loans. Here are some common types of loans that incorporate EMI:
1. Home Loans
Among the most common and significant uses of EMIs are home loans. As home loans become a long-term financial commitment for a borrower, running for 10 to 30 years, EMIs help the borrower repay his loan over the long term.
Current Indian home loan interest rates range between 8.30% and 8.75%. At the same time, many lenders offer slightly lower rates for excellent credit. Reference:
According to RBI data, outstanding growth in home loans was up by 13.8% to Rs 20.09 lakh crore in May 2024 compared to last year.
2. Personal Loans
Personal loans are the third category of loans, often serviced through EMIs. They are unsecured and do not require any collateral, so they are widely used to cover medical emergencies, weddings, or holidays in another country. The tenure is much shorter than home loans, and interest payable is higher (due to the lack of collateral).
3. Car Loans
Car loans constitute many secured loans, usually paid back through Equated Monthly Instalments. These loans are secured against the vehicle purchased, and the repayment tenure varies between 3 and 7 years. Indian auto financing disbursals of FY 2023 were at USD 48 billion and were expected to increase by 12%+ in 2024
4. Education Loans
Education loans form a significant component of financial aid offered to students pursuing higher education, whether in India or overseas. Most education loans provide a grace period during which the student is not expected to repay. The student starts paying EMIs only after completing that period or when he starts earning.
5. Consumer Durable Loans
Consumer Durable loans are used to make purchases of high-value commodities such as electronic goods, home appliances, furniture, etc. They have much shorter tenures, between 6 months and 3 years, and are available at competitive interest rates.
Consumer durables and electronic purchases on EMI now contribute nearly 45% of industry sales, up from around 15-20% five years ago. This is due to no-cost or low-cost EMIs, longer-tenure loans, zero-down payment options, cashback, etc.
6. Business Loans
Most business loans, whether secured or unsecured, are serviced through EMIs. These are taken for working capital, buying machinery, etc. They often help expand businesses or meet many other business costs.
Factors Affecting EMI: Key Elements That Influence Your EMI Amount
The following factors play a very critical role in defining the total EMI:
1. Interest Rate
The key factor that determines the EMI is the interest rate applied to the loan. This rate represents the cost of borrowing and is calculated as a percentage of the loan amount.
A higher interest rate results in a higher EMI, while a lower rate leads to a smaller EMI. Depending on the loan terms, the interest rate can be either fixed or floating.
- Fixed rate of interest ensures fixed EMI amounts.
- Floating rate of interest changes with a change in the market rates and causes fluctuations in EMIs over time.
2. Tenure of the Loan
The loan tenure is when the loan should be paid back. The longer the tenure, the smaller the monthly EMI, but the total interest will be higher. On the other hand, if the tenure is shorter, then the EMI will be larger, but the total interest paid over the loan amount will be reduced.
3. Principal Loan Amount
The principal loan amount refers to the amount one borrows from the lender. The larger the principal amount borrowed, the higher the EMI because interest and principal repayment are also calculated based on this amount.
4. Repayment Frequency
Although EMIs are paid monthly, some lenders offer flexibility in loan repayment schedules, like biweekly or quarterly payments. Repaying loans affects the EMI calculation and the loan payback amount. Therefore, the EMIs will be reduced, which could mean shorter loan tenure.
5. Credit Score
Another key determinant of EMI is a borrower’s credit score. Borrowers with a higher credit score are more likely to be offered loans at lower interest rates, reducing their EMI burden. On the contrary, a lower credit score may imply high interest rates, thereby increasing EMI.
6. Processing Fees and Other Charges
The processing fee is a one-time payment that indirectly influences the total cost of the loan and can influence the EMI. This can either be added to the loan, which increases the EMI. Other hidden charges, like late payment penalties or service fees, can also increase the effective cost of the loan.
Tips for Managing EMI: Strategies for Effectively Managing and Paying off EMIs
Use these essential tips and strategies to manage EMI payments efficiently:
- Choose Appropriate Loan Tenures: Individuals should strike a balance and assess their financial commitments before fitting an EMI within their monthly budgets.
- Higher Priority towards EMI Payments: Non-receipt of an EMI payment leads to an increased interest burden or damage to the credit score. To manage this, borrowers must consider making automatic payments or setting reminders so that no payment deadline is missed.
- Pay in Advance Whenever Possible: It is highly recommended to use surplus funds to prepay loans, as this will reduce the principal amount, interest burden, EMI amount, and tenure. Therefore, many lenders provide this facility without penalty charges. Use an EMI calculator to calculate the savings in periodic prepayment.
- Avoid Taking Multiple Loans at the Same Time: Taking too many loans increases the EMI burden and reduces the take-home income. It is best to repay existing loans before taking another loan. According to a report, the total EMI liabilities should not exceed 40% of gross earnings for smooth cash availability for all the other expenses.
- Loan Consolidation: Balance transfers or loan consolidation is useful if one has several loans at different interest rates. This allows consolidating all existing loans under one single loan against a lower interest rate with a manageable EMI. It streamlines the entire repayment schedule and reduces the interest burden.
Conclusion
Anyone planning to take out a loan must comprehend the term EMI in its full form, Equated Monthly Instalment. EMI allows the entire loan amount, with interest, to be paid in a series of fixed monthly instalments. This approach makes it easy for the borrower to manage his finances and cash flows.
Additionally, consider evaluating your financial situation regularly, setting a budget that accommodates your EMIs, and exploring options for loan refinancing if necessary to optimize interest rates.
FAQs
What is the full form of EMI, and how does it work?
In its full form, an EMI is an ‘Equated Monthly Instalment.’ It is the monthly amount that one needs to pay the lender to repay a loan or debt. EMI is a very popular mode of repayment as it empowers people to buy expensive things and pay for them in instalments.
What are the two methods of EMI calculation?
EMIs can be calculated using either the flat-rate method or the reducing-balance method. The EMI reducing-balance method generally works to the borrower’s advantage since it pays lower interest overall.
Can I reduce my EMI during the loan’s tenure?
Yes, borrowers can prepay their loans to reduce their EMIs or extend the loan tenure to lower their EMIs. They can also refinance their loans when interest rates come down, which reduces their EMIs.
What happens if I skip an EMI payment?
Missed EMI payments can degrade the credit score and may invite late payment fees and higher interest rates. It is always better to pay EMI on time to avoid debt stress and maintain a healthy credit profile.
