Unlike variable payment plans, which give borrowers the freedom to make payments whenever they’d like depending on their financial situations, EMIs have a clearly laid out repayment schedule and term to maturity. An equated monthly installment is ideal if you’d like to budget for your loan and know exactly what you’ll pay upfront.
Acronym: EMI Alternate name: Installment loans
How EMI Works
An EMI involves both principal and interest, as well as a loan’s term. The amount of each monthly payment will depend on the amount, duration, and interest rate of the loan. When you make your payments initially, most of the money will go toward interest. Over time, however, more of your money will pay down the principal. There are two ways to calculate EMI: the reducing-balance method and the flat-rate method. With the reducing-balance EMI, interest depends on the remaining portion of the loan and allows for lower interest payments over time. The flat-rate EMI looks at the original loan amount to calculate interest.
The Flat-Rate Method
To calculate EMI using the flat-rate method, you would first add the total principal of the loan and the total interest on the principal together. Then, you would divide the sum by the total number of payments, or the number of months during the loan term. Let’s say you take out a $50,000 loan with a 4% interest rate for two years. Using the flat-rate EMI, you’ll borrow a total of $4,000 in interest or about $166 monthly. Your EMI payments will be $2,250 per month. Flat-rate EMIs are widely seen in car loans and personal loans.
The Reducing-Balance Method
The calculation for the reducing-balance EMI looks like this:
P is the principal loan amountr is the monthly interest rate, i.e., the yearly interest rate divided by 12n is the total number of months you pay the loan
While you can do the formula by hand, typing it into an Excel spreadsheet is recommended. This is what the reducing-balance method looks like using our example: EMI= 50,000x(0.04/12)x[(1+(0.04/12))24] / [(1+(0.04/12))24-1] = $2,171.25 With this calculation, your EMI payments will amount to $2,171.25 a month. In this case, the principal amount paid back gets deducted from the outstanding loan amount, and interest for the subsequent year will be charged on the remaining deducted balance. It is not deducted from the entire loan amount, as it is in the flat-rate method. As mentioned, the reducing-balance method is typically preferred, as it’s considered more affordable than the flat-rate method, which often results in a higher interest rate. You’ll likely see a balance-EMI with a mortgage or credit card.
