Are EMIs helping or hindering your financial planning? A smarter approach
EMIs play a key role in personal financial planning. They offer a convenient means to reduce loan obligations by making payments at specific intervals.
Knowledge of EMIs can help an individual plan and execute high-valued purchases without worrying about upfront costs. In other words, EMIs offer the freedom to fulfil goals by taking out loans and repaying them without significantly impacting the monthly budget.
According to a survey conducted on 1500 borrowers across 16 different cities in India, over 50% of respondents preferred the EMI method to pay for their purchases. It indicates the growing significance of EMI in the context of financial transactions.
This blog offers detailed insights into EMI and its various aspects, including EMI’s full form, meaning, calculations, and more.
What Is EMI: Decoding EMI Full Form, Definition, and Meaning
The EMI full form is Equated Monthly Instalment. EMI refers to a fixed amount that a borrower pays for loan repayment every month on a specific date.
When an individual takes out a loan under an EMI plan, the principal sum and the borrowed interest are divided into smaller, equal amounts for easy repayment. The borrower must pay this amount to the lender at regular monthly intervals, which is the EMI.
So, the fundamental concept of EMI is that it allows a borrower to repay a loan gradually through equal monthly instalments. One doesn’t have to repay the entire loan amount and interest in one go, which can be strenuous for many borrowers. The date set for the instalments is determined while providing the loan.
Lenders today provide EMI for all kinds of loans, including personal, home, vehicle, and education loans. Whether one wants to purchase a high-end mobile phone or property, the EMI method makes it easy to attain such goals.
How Do EMIs Work?
An important aspect of EMI is that it remains constant during the loan period. Borrowers are not allowed to change the EMI amount at their convenience.
This set sum ensures better money management for lenders and borrowers. Borrowers who choose the EMI option know the monthly payment amount they must set aside to pay back their debts, enabling them to manage their monthly budget appropriately.
Conversely, lenders may get a set amount in exchange for the borrowers’ EMI payments. The rising acceptance of EMIs can be attributed to both of these phenomena.
When paid, an EMI is divided into two halves: the principal and interest are partially repaid. The outstanding loan amount gradually drops as the number of EMIs repaid increases.
The number of EMIs required to repay a loan is determined during processing. This number can range from a few months to several years. For instance, if a loan is to be repaid in 9 EMIs, the loan tenure is nine months.
After an individual pays the last EMI, the lender closes the loan. A borrower can reduce the number of EMIs by partially repaying the outstanding loan amount. It is also possible to foreclose the loan by repaying all the outstanding EMIs.
Methods to Calculate EMIs
EMIs are calculated using the fixed-rate method and the reducing balance method. Understanding how EMIs are calculated is essential for choosing the right option and managing debt efficiently.
EMI calculations involve three factors.
· Principal Amount
· Loan Tenure
· Interest Rate
Fixed-Rate Method
Using the fixed rate technique, the lending rate is fixed for the duration of the loan. Alternatively, the fixed interest rate is maintained for the duration of the loan.
As a result, the principal and interest components stay the same for the duration of the EMI. This EMI amount split is independent of the quantity of EMIs paid or the amount reimbursed through EMIs. Another name for it is the flat rate approach.
Here, the interest is calculated for the total loan amount at the beginning of the loan period. To calculate the EMI, this interest is added to the loan amount. The sum is then divided by the loan tenure expressed in months.
EMI calculation using fixed-rate methods is as follows:
((P x R x N) + P)) / (N x 12)
Where,
P is the loan amount
R is the interest rate
N is the loan tenure
Let’s understand this with an example.
Suppose an individual borrows Rs. 6,00,000 at an interest rate of 15% for four years. As per the fixed-rate method, the EMI will be:
EMI = ((6,00,000 x 15% x 4) + 6,00,000) / (4 x 12) = 9,60,000 / 48 = 20,000
So, the borrower will have to pay Rs. 20,000 as EMI every month.
Reducing Balance Method
The reducing balance method calculates interest on the outstanding principal amount after each EMI payment. An EMI has two components: principal and interest.
When a borrower pays an EMI, the principal amount is reduced. The interest is calculated based on this reduced principal for the next EMI. This process continues throughout the whole loan tenure.
Here, the interest depends on the principal amount that is yet to be repaid. So, the interest component of the EMI remains high and the principal component low during the initial phases of the loan repayment.
Gradually, the interest component decreases, and the principal component of the EMI increases, causing the outstanding loan amount to decrease.
The formula to calculate the EMI using the reducing balance method is as follows:
P x R x (1+R) ^ N/ [(1+R) ^ (N-1)]
Where,
P is the loan amount
R is the monthly interest rate (the annual interest rate is divided by 12 to find the monthly interest rate).
N is the loan period in months.
Let’s take an example and try to understand how to calculate EMI using this formula.
Suppose an individual borrows Rs. 28,00,000 at an annual interest rate of 9% for five years.
Here, P is Rs. 28,00,000, R is 0.75% (dividing 9% by 12), and N is 60 (converting five years into months).
As per the reducing balance method, the EMI will be:
EMI = 28,00,000 x 0.75 x (1 + 0.75%) ^ 60 / [(1 + 0.75%) ^ (60 -1)] = 58,123
So, the borrower will have to pay Rs. 58,123 as EMI every month. The total interest will be Rs. 6,87,404, and the total amount to be repaid for this loan will be Rs. 34,87,404.
However, using a mathematical formula to calculate the EMI can be time-consuming and complicated. An easy alternative is to use an online calculator by PowerUp Money to calculate EMI accurately and instantly.
Impact of EMI on Personal Financial Planning
Personal financial planning and budgeting are essential for ensuring a stable financial future. While taking out loans has become convenient, it is important to plan an effective loan repayment schedule without undue financial stress. This is where EMI can make a big difference.
EMI can empower one to remain on track with personal financial planning and budgeting.
Enhanced Affordability
From financing a sudden trip to overcoming a medical emergency, loans offer a convenient means for meeting all such expenses. EMIs act as the key to repaying the loans through manageable monthly payments.
Increased Purchasing Power
EMIs enable individuals to make large purchases, such as cars, properties, etc., without impacting their monthly budget. It gives them the power to finance purchases they won’t be able to pay for upfront.
Budget Management
EMIs help to distribute the repayment of large expenses over a large period. This allows one to manage them without facing a financial crisis every month.
Creditworthiness
Timely payment of EMIs can help an individual establish creditworthiness. A high credit score can help one easily secure future loan approvals and get a better interest rate.
Conclusion
EMI offers a convenient means of planning personal finances and meeting large expenses without impacting the monthly budget. However, knowing EMI’s full form or meaning is not enough.
Understanding how EMIs work and applying the concept to financial decisions can make all the difference. What’s important to remember is that EMI can make repaying loans stress-free. It can help one fulfil loan repayment obligations without compromising on other expenses and investments.
FAQs on EMI
What Is EMI Eligibility?
Banks and financial organizations offering loans have certain eligibility criteria for EMI eligibility. To secure a loan that can be repaid through EMIs, one has to fulfil the eligibility criteria of the potential lender.
What Is the Maximum EMI Rule?
A widely accepted rule is that one must not spend more than 35% to 40% of one’s income on paying EMIs. This ensures that an individual has enough money to meet other expenses after paying the EMI.
What Is the Advantage of Paying EMIs in Advance?
By paying advance EMIs, an individual can save on interest. This helps to reduce the outstanding loan amount, decreasing the total interest paid over the loan tenure.
