With both individuals and businesses increasingly turning towards loans to fund their activities, understanding their financial impact becomes crucial. When you opt for a loan, you become legally obligated to pay EMIs regularly until the end of the chosen loan tenure to pay off the borrowed amount along with the interest.
But then, what is EMI and which formula is used to find EMI? In this article, we are going to address both of these questions and explore how the loan calculation formula works with the help of a hypothetical example.
What is EMI?
Before we look at how to calculate EMI and interest components on a loan, let us first address the concept of EMIs.
Equated Monthly Installment, commonly known as EMI, is a fixed amount of money paid by a borrower to a lender on a specified date each calendar month. The EMI has two components: principal and interest. The principal refers to the amount borrowed from the lender, whereas the interest refers to the charge that the borrower must pay to the lender to avail of the loan.
One of the noteworthy characteristics of EMI is that it remains constant throughout the entire tenure unless there is a change in the rate of interest. Another fascinating aspect is that the proportion of principal and interest changes over the course of the loan. During the initial phases of the loan, a larger portion of the EMI goes towards interest. However, this gradually shifts towards more principal repayment as the loan progresses.
How to Calculate EMI?
Equated Monthly Installments are calculated using a specific EMI formula that takes into account the loan amount, interest rate, and loan tenure. Let us look at the mathematical formula that is used to determine the EMI for a typical loan.
EMI Formula = {P x R x (1 + R)N} ÷ [(1 + R)N – 1]
Here,
- P represents the principal or the amount you borrowed from the lender.
- R represents the monthly rate of interest applicable for the loan. It is calculated by dividing the annual interest rate by 12 and then again by 100.
- N represents the tenure of the loan in months.
Although the EMI calculation formula mentioned above can be used to manually estimate monthly loan obligations, it is often a very extensive and time-consuming exercise that is susceptible to errors and mistakes. Fortunately, with a tool like an EMI calculator, you can instantly estimate your loan obligations with a high degree of accuracy.
EMI Calculation Example
Let us take the help of a hypothetical example to fully understand how to calculate EMI.
Assume you wish to take a loan of ₹20,00,000 for a tenure of about 20 years (240 months). The annual interest rate on the home loan is 8%.
Before we use the EMI formula, let us first convert the annual interest rate into a monthly interest rate in decimals.
Monthly Interest Rate (R) = 0.0067 [(8 ÷ 12) ÷ 100]
Now that we have all the variables, let us substitute them in the EMI calculation formula mentioned above.
EMI = {₹20,00,000 x 0.0067 x (1 + 0.0067)240} ÷ [(1 + 0.0067)240 – 1]
EMI = ₹16,729
Therefore, the EMI for this loan would be ₹16,729 per month for 20 years, meaning that over the entire course of the loan, you would have paid a total of ₹40,14,912 .
The interest component of this loan can be calculated by subtracting the loan amount from the total amount that you would pay throughout the entire loan tenure, which would amount to ₹20,14,912 (₹40,14,912 – ₹20,00,000).
Factors Impacting EMIs
Now that you are aware of how to calculate EMI and interest on a loan, let us quickly go through some of the key factors that can impact the Equated Monthly Installment amount.
1. Principal Amount
One of the key factors impacting the EMI is the amount you borrow as a loan. The higher the loan amount, the higher your monthly loan obligations will be.
2. Interest Rate
The interest rate is also a major factor contributing to the EMIs. A higher interest rate leads to a higher EMI. In fact, even a small spike in the interest rate can significantly impact the EMI over a long-term loan.
3. Loan Tenure
The tenure over which you pay a loan is another deciding factor. A longer loan tenure typically results in lower EMIs but higher total interest paid over the life of the loan. On the other hand, a shorter tenure often leads to higher EMIs but less total interest paid over the life of the loan.
4. Type of Interest Rate
In fixed-interest-rate loans, the EMIs stay consistent throughout the loan tenure. However, in floating interest rate loans, the EMIs can increase if the interest rates in the market increase.
5. Prepayment or Part Payment
Prepayment or part payments reduce the amount of borrowing significantly and can either lead to a reduction in the future EMIs or the loan tenure.
Conclusion
Understanding the EMI formula and how it works is essential for anyone considering a loan. Now that you are aware of the calculation process, you must now be able to plan your finances better, compare different loan options, and make informed decisions about borrowing and repayment.
It is important to remember that although the loan calculation formula can be used manually, it could potentially result in erroneous results due to mistakes or omissions. For highly accurate estimations, consider using an online EMI calculator. These tools can compute your loan obligations within seconds and enable you to construct different scenarios by changing the various parameters.
FAQs
Can I change my EMI amount during the loan tenure?
No. The EMI is generally fixed. However, if you make partial payments or refinance your loan, the Equated Monthly Installment may either increase or decrease depending on the terms of the new or revised loan.
How does a change in interest rate affect my EMI?
If you opt for a floating interest rate loan, an increase in the interest rate can increase your EMI or extend your loan tenure, depending on the agreement with your lender.
Does my credit score affect my EMI?
The credit score does not directly affect the EMI calculation. However, a better credit score can help you get lower interest rates, which in turn leads to lower EMIs.
What is an EMI calculator?
An EMI calculator is a tool that estimates your monthly instalments based on inputs like the loan amount, interest rate, and tenure.
How does EMI calculation differ for fixed and floating interest rate loans?
For loans with fixed interest rates, the EMI remains constant throughout the tenure. However, for floating or variable interest rate loans, either the EMI or the tenure may vary when the interest rates change.
