Repaying a loan? Understand EMIs first!

hat on earth is an EMI? That is what one reader asked us.

Whether you go for a car loan, personal loan, home loan or any loan, you will get this term thrown at you.

So let's demystify it.

1. What is an EMI?

Simply put, it is the acronym for Equated Monthly Installment. This is the amount of money you will have to pay every month in order to repay your loan.

Since you will be dishing out an EMI on a monthly basis, the 12 installments at the end of the year are referred to as equated annual installment -- EAI for short. However, this term is not used as frequently.

So if your EMI is Rs 4,400, your EAI would be Rs 52,800 (4400 x 12).

2. Does it remain equal through the repayment tenure?

Barring a few exceptions, the EMI stays constant.

The exceptions are:

• When you pre-pay part of your loan. Then, the EMIs for the remaining period of your loan reduce in size. This happens if you decide you stick to the tenure of your loan. Alternately, you can choose to stick with the same EMI and finish paying your loan earlier.
• When you opt for a balance transfer at a lower interest rate. This means you have decided to switch your loan to another financier offering a lower rate of interest; as a result, your EMI will change.
• When you opt for a step-up (when your EMIs increase over time) or step-down (when your EMIs decrease over time) facility.
• If you opt for a flexible rate loan, the EMI changes according to the movement in the interest rates.

3. What is the EMI made up of?

An EMI is an unequal combination of your loan amount and its interest.

The EMI remains constant through the repayment period. So if your EMI is Rs 4,400 for five years, then this is the amount you will pay for the 60 months that form the duration of your loan. 

The composition of the EMI, however, changes over time.

At the start of the loan, EMIs are heavily tilted towards interest payments. Towards the end of the loan, the EMI tilts towards principal repayments. Hence, you end up paying more since the principal gets paid only at the end of the tenure.

Confused? Check the example below.

Let's take a 15-year loan.

In the first year of repayment, your interest payment would comprise around 85.99% of the EMI while the principal repayments would only 14%.

In the last year, your interest payment would comprise around 12.28% of the EMI while the principal payment would form 87.71%.

4. What goes into the determination of an EMI?

Four factors actually.

• The principal (the actual loan amount).
• The repayment period (the number of years you will take to repay the loan).
• The rate of interest.
• How the rate of interest is computed (monthly reducing, quarterly reducing or annual reducing basis).

5. What are the personal factors that are considered?

When sanctioning a loan, the financier will look at your income. S/he will want to know how much you can afford to pay every single month and how much you are comfortable paying every month.

Generally, the financier does not allow the EMI to exceed 35% to 45% of the individual's gross income. If the money is likely to put too much strain on the individual, the chances of default are higher.

Sometimes, exceptions are made if the individual's earnings are high; in such cases, financiers can go up to 60%.  

However, if your EMI is working out to be as low as 20% of your gross income, you could negotiate for a higher EMI. On the flip side, the financier may think you can afford to pay around 50% of your gross income but you may be comfortable with less.

Ultimately, it depends on how much you are willing to pay, to what extent you are willing to compromise on your lifestyle and on the duration of the loan.