What is EMI Meaning, Full Form and How it Works?

EMI full form stands for Equated Monthly Instalment. It refers to a fixed monthly payment structure used to repay borrowed funds.

Each instalment consists of two key parts: the principal and the interest. The principal, which gradually reduces the outstanding balance, and the interest, representing the cost of credit. 

EMI plays a crucial role in the overall personal financial planning of an individual. Due to the time value of money,  the loan is accompanied by the interest costs in EMIs. However, understanding what is EMI and its mechanism in detail can significantly help borrowers plan it.

Here’s a guide to understand the EMI meaning in detail, its advantages in financial planning and the crucial factors affecting EMI.

How EMI works?

As noted earlier, EMI meaning is associated with loan repayment at an equally spaced interval.  However, understanding its working can help borrowers plan this repayment. Here’s the procedure of EMI:

• While procuring the loan, the banker calculates the interest, EMI and total loan amount based on the period, interest calculation method, purpose, etc.
• The EMIs are the equal amounts to be paid monthly at a fixed date and include the part of both the principal and interest.
• payment reduces the loan amount over a period and closes the loan after the decided period.
• Borrowers can also get a No Objection Certificate (NOC) from the lending authority to exhibit their EMI payments or remaining loans.
• If suitable, one can prepay the loan as per lending conditions.

EMI calculation is not just dividing the total loan amount by the number of instalments. It requires a proper balance of principal and interest in the loan. Let’s understand the formula for such EMI calculation.

EMI Formula

To calculate this formula, we require components like principal amount, interest rate and tenure as input.

Equated Monthly Instalments (EMI) = (P x R x (1+R)^N) / (1+R)^N  -1

Here, 

• P = Principal amount 
• R = Rate of Interest/100 
• N = Number of years or tenure of the loan in months.

In this formula, we account for the interest rate and its effect on the loan based on the time value of money. However, this calculation is also affected by the method of calculation. 

Types of EMI

EMIs are categorised into two types based on the interest rate:

1. Fixed Rate

The interest rate remains unchanged throughout the term, ensuring equal monthly payments. A predetermined calculation method applies, making financial planning straightforward. 

2. Floating Rate

Here the component of EMI may change. This change is settled by adjusting the tenure or EMI amount as per the credit norms and the borrower’s suitability.

How is EMI calculated?

Understanding the EMI meaning should be accompanied by evaluating and selecting a suitable EMI calculation method. Mainly, these two methods are used for EMI calculation:

1. Fixed-Rate Method

As the name suggests, the interest rate in this method remains the same and is calculated when the loan commences. Usually, a change in the repo rate directly affects the interest rates of retail loans. However, in this method, no change will be reflected. The EMI will be calculated by adding total interest to the principal and dividing this sum by the tenure in months. Let’s simplify this method with a hypothetical example:

Mr X procures a loan of ₹20 lakhs for 15 years at an interest rate of 8.5%. The EMI for this loan will be calculated as follows:

Total interest = 20,00,000*15*8.5% = 25,50,000

Total Amounts = Interest + Loan Amount

Total Amount = 25,50,000 + 20,00,000 = 45,50,000

EMI = Total Amount / (Years*12)

EMI = 45,50,000/(12*15) = ₹25,278 (approximately)

2. Reducing Balance Method

In this method, the outstanding balance of the loan is ascertained to calculate the interest obligation. Here, after an EMI payment, the principal will be reduced by further reducing the interest amount. Due to the reduction in the base, the interest liability reduces over time. Let’s understand it with the example given above:-

• P = ₹20 lakhs 
• R (monthly) = Interest /12 = 8.5/(100*12) = 0.0071 
• N = 15 years or 180 months (15*12)

The formula is mentioned above in the article.

EMI =(P x R x (1+R)^N) / (1+R)^N  -1

EMI = ₹19,694 (approximately)

Factors Affecting EMI

Merely understanding what is EMI may not help borrowers sufficiently plan their loan repayment. They should also assess the factors affecting EMI amount and payment frequency. Some of these factors are as follows:

• Monetary Policy: In India, the Reserve Bank of India (RBI) is liable for designing monetary policy. Assessing the money flow in the economy, if the RBI changes repo rates, the bank lending rates are directly affected. The interest rate while procuring affects the EMI calculation.
• Loan Tenure: One can adjust the EMI amount by changing the tenure. The higher the tenure, the lower the interest rate. Some lending institutions also allow flexible EMIs by adjusting this tenure.
• Purpose: The borrower’s purpose for loan procurement affects several aspects of that loan. Some loan types have inherently longer tenure and different interest rates. It can further affect the calculation of EMIs for that loan. 
• Creditworthiness of the Borrower: Lenders usually assess the creditworthiness by credit score. A higher credit score can help manage suitable loan interest rates and other terms. Moreover, EMIs can indirectly affect a borrower’s loan repayment frequency and credit score.
• Lending institution: The EMIs and other conditions are decided by the lending institutions, which may affect the EMI calculations. 

Conclusion

Understanding the full form of EMI—Equated Monthly Instalment—is crucial for its calculation and overall management of the credit. One can plan their loan repayments by planning EMIs. There are different methods for its calculations. Borrowers can compare them, analyse other conditions and plan their loan repayment process.ulations. Borrowers can compare them, analyse other conditions and plan their loan repayment process.