The first thought which comes to our mind when we are looking to borrow money for buying a Car, A House, Personal Loan, Medical loan is the EMI. EMI stands for Equated Monthly Instalments to payback the money we borrow. The idea of EMI comes from the fact that we all strive to attain a certain stability and this paying back an equal amount over a fixed number of months helps us to determine our cashflows. A sudden requirement of cash can be managed by converting it into EMIs which spreads over the need to payback over a pre-determined period, at a cost.
Let us see what goes behind EMI. Each Each monthly payment has got two components- The Principal amount and Interest paid. The composition of EMI between these two components varies each month. Whenever a loan is taken the majority portion of the EMI is the interest cost and only a small part of it goes in prepaying the Principal amount. But slowly as the time passes, the principal still outstanding starts falling and thus the interest component reduces.
Gullakh highly recommends prepaying part of the loan in the initial years as it helps reduce the total interest paid significantly and helps reduce the EMI.
How is EMI constructed:
EMI is calculated based on three factors: The Loan Amount; Rate of Interest on the Loan & the Tenure (Number of years/month for which loan is taken) of the Loan. Tweaking any one of them could alter your EMI. There are multiple Online tools available to calculate the EMIs trying various combinations to help you do a cost-benefit analysis.
EMI usually changes under following circumstances:
Floating Interest Rate Loan: If thats the kind of loan one has taken, the rate undergoes a revision with a pre-determined frequency, usually every 6 months or annual. So everytime it is reset, it will impact your EMI. Though most of the banks offer the customer a chance to alter their Tenure of the loan so that the EMI remains the same. Always do the cost-benefit analysis while changing the tenure of the loan as it comes with a cost attached. Interest outgo over the entire payment of loan also changes when you change the tenure.
Prepayment of Loan: Everytime you make a part-prepayment of your loan, the Principal outstanding is reduced by that amount and accordingly your EMI goes down. Home Loans for Individuals doesn’t have any Pre-payment charges and it is thus a good idea to payback some of the amount in the early years.
Progressive EMIs: Certain banks offer this product which is more suited for people who have recently started their careers and are expected to grow fast. This offers you a flexibility of lower EMIs in the initial period and as the time progresses the EMI increases at pre-decided times. This is based on the assumption that the individual progresses in organisation with better salaries and perks, over time.
Do your groundwork and understand EMIs well before you make your final choice