EMI - Smart way to MANAGE your Debt

EMI is the most common acronym in the world of borrowing today. EMI stands for Equated Monthly Installment. This is the amount paid every month as long as the loan amount is outstanding, which goes towards both the interest & principal repayment. Though, EMI is the unequal combination of principal and interest repayment, overall it remains constant throughout. Looks simple, but the calculation of EMI greatly differs in the industry.
Initially, a major part of the EMI goes in paying the interest only. As the tenure approaches the end, the principal repayment component increases.
Factors effecting EMI
• Rate of interest
• Loan Amount
• Loan tenor
Amount of EMI is inversely proportional to the tenor of the loan, assuming the loan amount to be the same. For instance, EMI for a personal loan of Rs.2, 00,000 at 20% interest rate will be like this:

Increase in Tenor

TENOR EMI 1 year Rs.18526 2 years Rs.10179 3 years Rs.7432 4 years Rs.6086 5 years Rs.5298

Increase in EMI

From the above table it is clear that for the same Loan Amount and rate of interest the EMI is inversely related to the tenor.
How EMI is calculated?
There are types of two methods to calculate the EMI
- Flat rate system
In the flat rate system, the rate of interest on the loan amount is calculated over the entire duration of the loan and the principal plus the interest is divided over the number of installments and the value arrived is your EMI. Interest charged on the full amount of a loan throughout its entire term. The flat rate takes no account of the fact that periodic repayments, which include both interest and principal, gradually reduce the amount owed. Consequently the effective interest rate is considerably higher than the nominal flat rate initially quoted.
Lets Take an Example:
Rs.5, 00,000 is the Loan Amount taken for 5 Years at Flat rate of interest of 15% p.a.
In this case, you have to pay Rs. 75,000 every year as interest (15 % on Rs. 5,00,000). So for the tenure of 5 years you will need to pay Rs. 3,75,000 (Rs. 75,000 x 5 years) as interest on the loan. The EMI that you would need to pay for the 60 months will be Rs. 14,584 ( Rs. 5,00,000 (principal) + Rs. 3,75,000(interest) / 60 months).

End of Year	Interest paid	Balance Principal
1	75000	400000
2	75000	300000
3	75000	200000
4	75000	100000
5	75000	0

- Reducing Balance System
Reducing balance is the method of reducing the principal amount repaid, from the outstanding loan amount. In this case, the interest is charged on the outstanding principal balance of the loan, which goes on reducing.

The reducing balance can be further classified on the basis of number of times the principal is reduced/credited in a year as
• Daily reducing balance: there is immediate reduction in principal thereby reducing the interest calculated on it.
• Monthly reducing: the principal component is deducted at the end of every month and then the interest is calculated on this new outstanding reduced principal.
• Quarterly reducing: principal is reduced 4 times a year.
• Annual reducing: the principal component of EMI though reduced every month, is summated annually. Therefore, the interest is calculated on the original loan amount for the entire year. At the end of the year, the accumulated principal component is deducted from the original loan amount and the interest for the next year is on this reduced loan amount.
Lets find out the effect of the different methods of EMI calculation

Method of calculation	Annual reducing	Quarterly Reducing	Monthly reducing	Daily Reducing
Loan Amount (Rs)	100000	100000	100000	100000
Interest rate (%)	10	10	10	10
Tenor / Periodicity of Payment	1Year	4Quaters	12 Months	365 Days
Payment Amount (Rs)	110000	26581.78	8791.50	287.937
Total interest Paid (Rs)	10000	6327	5500	5097
EMI (Rs)	9166	8860	8791	8610

The table above clearly shows that EMI pay out for the same loan amount, interest and years, is the lowest in case of Daily reducing balance method and the highest in annual reducing balance method.
This is because in the case of daily reducing balance method you are required to pay interest on the principal, which is reduced every day. But in case of annual reducing balance method, the principal is reduced once in a year, that too at the end of the year.
Another method by which EMI can be classified in case of home Loan is:
• Step up EMI: This facility is extended, keeping in view the prospective increase in income of the Borrowers, and is available to people who have good prospect of future increase in income, viz., young Professionals/Executives. This facility envisages flexible mode of repayment through Stepping up of EMI during the tenure of loan. Under this Facility, the EMI will initially be fixed at a lower amount; this would be changed twice during the Loan Tenure.
• Step down EMI: Here the scheme is structured that an EMI decreases each year until the end of the tenor. The first year is the highest and the last year is the lowest.
• Balloon EMI: A Balloon EMI scheme allows a one-time payment at the end of the tenor of up to 20% of the principal. The interest is however calculated for the entire principal and is recovered in the monthly installments
• EMI on Fixed Rate Of Interest: In case of fixed interest rate home loan scheme, the interest rate charged by HFCs remains fixed or same throughout the term of the loan.
• EMI on Floating Rate of Interest: Under this scheme, the rate charged varies with a benchmark, which is the generally prime lending-rate (PLR).
Given the current market condition, the interest rates would remain flat or increase by a couple of percentage points over the next couple of years, but if the central bank wants to keep the economy on a high growth path, it needs to bring down lending rates for priority sectors like housing. So, Floating rate Loan is better option than Fixed rate Loan for Home Loan.
EMI is the simplest and most commonly availed scheme.The EMI remains the same throughout the tenor.
Modes of EMI payment:
There are two types:
i. Monthly in Advance: Here the first installment is paid in advance. The number of installments is equal to the number of months in the tenor [for example: 60 installments if the tenor is 60 months.
ii. Monthly in Arrears: The first installment is due at the end of each month. The number of installments would be one less than the months in the tenor [for example: 59 months if the tenor is 60 months]. The interest rate for an arrears payment would always be slightly higher than the advance payment.
Payment of EMIs is usually through the below given modes
• Electronic Clearing Service (ECS)
ECS is primarily used for receipts and payments which are of a small value and which are generally repetitive in nature. ECS can be divided into two types: ECS Debit and ECS Credit. An ECS Debit involves making utility bill payments directly from your bank account, EMI payments on loans, undertaking investments, etc.
• Payment by cash
• Payment by Draft
• Post Dated Cheques (PDCs)
• Electronic Fund transfer
• Standing Instructions on Bank Account / Credit Card

EMI Defaults
Normally defaults on EMI payments are made when you dont have the cash with you due to salary not credited or extra expenditure. So the most important point while deciding for an EMI is:
• Amount Of the EMI: The amount of the EMI should be such that it is feasible for you to carry that throughout the tenor of the Loan.
• Date of the EMI: Date at which the EMI is to be paid to the bank should be decided keeping in mind that whether your salary will be credited in your account till that or not. Example: if your salary date is 7th of every month then your EMI should be paid on 10th-15th of every month to keep all things going.

So, the crux of the article is that you should choose your EMI on reducing balance system (monthly). And EMI should be decided keeping in mind the amount of the EMI and the dates at which it has to be paid the banks should be in sync with the date on which your salary is credited to avoid the defaults in payments.

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