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Home loans & EMIs
September 10, 2012

Once you understand the composition of your EMI you will see that pre-payment makes much more sense during the initial repayment period of the loan. You will also know why the interest calculation matters.


Author : iFAST Content Team



 All about EMIs

If we ask you what an EMI is, your instant retort would be that it is the amount a borrower pays every month towards his loan. You are right. But get into technicalities or nuances and chances are you will draw a blank.

It’s time to get down and dirty with EMIs!

What it is

An Equated Monthly Installment (EMI) is the amount you pay every single month to the lender. It is an (unequal) combination of principal repayment and interest payment. You will see that this inequality of principal and interest has a significant implication on your repayment decisions and tax impact.

Loan amount: Rs 1 lakh
Interest: 8.75% p.a.
Tenure: 5 years (60 months)
EMI: Rs 2,064

 

First 30 months

Last 30 months

Total of 30 EMIs

Rs 61,920

Rs 61,920

Interest paid

Rs 17,340

Rs 6,484

Principal repayment

Rs 44,580

Rs 55,420

Click here to see the entire loan repayment schedule in an excel format.

As you can see, though the amount of the EMI remains static, the underlying composition is dynamic. Since the earlier part of the loan repayment is predominantly interest payments, it makes a lot of sense to prepay the loan at this stage. Prepaying the loan in the second half of the tenure does not make too much of sense since the bulk of interest payments have already made. Prepaying the loan in the initial years reduces the principal amount which immediately lowers the interest burden too.

Naturally, your tax impact also matters. The home loan company or bank will give you a certificate at the end of the financial year telling you exactly how much you paid that year by way of interest and principal so you can claim your benefits accordingly.

Do note, we are taking a static example into account. If you opt for a flexible rate loan, your EMI could rise while tenure stays constant or the EMI could be constant while the tenure increases.

How the calculation of interest rate affects it

The lender will use two ways to calculate the interest payment. A flat rate of interest is the most expensive but is not employed by home loan lenders. The other two ways are mentioned below.

Annual reducing balance: The lender calculates the outstanding loan at the end of the year. So even though you pay a monthly EMI, the principal outstanding reduces not every month but end of the year.

Monthly reducing balance: The lender does the calculation at the end of every month. So the principal reduces by a small amount every month resulting in the interest payment too dipping marginally.

Loan amount: Rs 10 lakh
Interest: 8% p.a.
Tenure: 10 years (120 months)
EMI (annual reducing): Rs 12,419
EMI (monthly reducing): Rs 12,133

What you need to remember…….

  • Principal: The larger the loan amount, the greater the impact on the EMI
  • Rate of interest: Higher the interest, higher the EMI
  • Tenure of the loan: Lesser the tenure, greater will be the EMI
  • Calculation of interest rate: Monthly reducing balance helps you save more than an annual reducing one

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