EMI is the abbreviation for Equated Monthly Installment. EMI is the monthly repayment that borrower should make to repay the loan as per amortisation schedule.
Loan Amortisation Schedule is the table, which details the following
Each EMI repays a part of principal i.e. the borrowed amount and the interest due on the borrowed amount. The proportion of each EMI utilized for repayment of principal and interest, however, varies over time.
Banks and financial institutions, in general, calculate EMI through a common mathematical formula. Thus, for a given loan amount, tenure and interest rate, the EMI calculated and the amortisation schedule offered by banks and Non-Banking Financial Companies (NBFCs) will typically be similar. This means that pattern of reduction of principal amount through payment of each EMI will typically follow similar trend across all financial institutions.
It is a well-known fact that the initial EMIs contribute more towards payment of interest due as compared to the principal amount. However, during the tenure of the loan, subsequent EMIs contribute more towards repayment of principal amount as compared to previous EMIs.
Since EMI is the fixed amount that you will need to pay to the bank towards repayment of your Loan, calculating the EMI helps you to plan your monthly budget.
Part payments reduce the outstanding loan amount, which in turn reduces the interest amount due. Without changing the EMI post part payment, the contribution of EMI towards principal repayment increases. Thus the loan gets repaid faster.
Although EMI stands for Equated Monthly Installments, it does not mean that it will never change. When availing the loan, you estimate your EMI by taking into account a fixed loan amount with fixed rate of interest for fixed loan tenure. However situation can change over time and many factors could alter your EMI amount. So let us explore these reasons in detail.
Interest rates can change multiple times during the tenure of the loan. This can impact the borrower either positively, negatively or not at all depending on the type of interest rate chosen. Different lenders (it may be banks or HFCs) offer different interest rates on loans. Further, these lenders offer different types of interest rates. Increase or decrease in general interest rates can impact your EMI.
If you have taken a loan under the floating rate of interest then your EMI may change according to the change in the rate of interest. The rate of interest on home loan changes as and when the RBI changes the bank rate. If you have opted for the fixed rate of interest then the change in bank rate may not affect you. But nowadays only a very few banks offer the fixed rate of interest. On the other hand, if you took a loan under the floating rate of interest then is ready for increase or decrease in your EMI or alternatively you may opt for the change in the loan tenure.
Most banks allow you to repay the loan ahead of schedule by making lump sum payments. Any extra payments over and above the monthly EMI would bring down the outstanding principal amount and reduce your interest burden. After taking loan and paying EMI for a few years, if you want to repay the remaining amount all at once and want to get rid of the burden of loan, you can do so. But, usually the lenders charge 1-3% on the outstanding principal amount as penalty. Some lenders waive this if the prepayment is up to 25% of the outstanding loan amount in a year. Prepayment penalty may vary according to the reasons and source of funds – if you obtain a loan from other financial institutions for prepayment, the charges are usually higher than when you pay from your own sources.
Is it wise to prepay the loan? The answer is yes and no. If the interest that you are paying on your loan is higher than the returns you are earning from your investments then it is better to pre-close the loan. Moreover, you will be free of debt and can enjoy the mental peace by paying all your debts. Some banks charge prepayment penalty only if you are refinancing it through another lender but if you are paying it from your own funds then they may reduce the charge or waive the penalty altogether.
If you negotiate a new loan term with your current lender or switch over to a new lender with a new loan term, then your EMI amount would change accordingly. The longer the tenure of the loan, the lesser will be your monthly EMI payment. Shorter tenures mean greater EMI burden, but your loan is repaid faster. Longer tenures mean payment of larger interest towards the loan and make it more expensive.
Some financial institutions offer their customers flexible repayment options with unequal EMIs. In step-up loans, the EMI is low initially and increases as years roll by (balloon repayment). In step-down loans, EMI is high initially and decreases as years roll by. Step-up option is convenient for borrowers who are in the beginning of their careers. Step-down loan option is useful for borrowers who are close to their retirement years and currently make good money.
EMI, especially one you are paying for your home loan, is a big chunk in your monthly budget so plan properly about your EMI payment and be prepared for any change that may occur in future.