RBI Issues Circular On Levying Unfair Interest Charges On Customers

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The term “EMI” is quite a familiar one these days and is not limited to just home loans or personal loans. Even credit cards offer customers schemes wherein the payments can be done by way of EMI’s. We now live in an era where purchases and payments have shifted base to online mode, and a lot of online shopping apps offer schemes such as “Pay Later” wherein the customer can purchase the required products and pay later in EMI’s. EMI schemes are quite popular these days especially while buying gadgets and appliances, which makes it easy to procure high-end devices. However, though these might appear to be “blessings in disguise”, quite literally. It is important to know the various components of the term “EMI”.

EMI — the short form for Equated Monthly Instalment, is a fixed sum of money that is paid by the borrower to the lender of funds at a specified date every month for a certain period of time. An EMI consists of two main elements —  the principal and the interest. It is very important for the borrower to understand these two components, especially the computation of EMI by banks prior to opting for loans from any financial institution.

Components of EMI

An EMI consists of two important components: Principal and Interest. When a loan is sanctioned to an individual, the interest amount would be high initially in contrast to the principal. With time, there is a rise in the principal amount and the interest amount gets reduced. There are a few Flexi loans that allow the borrower to pay just the interest amount as EMI’s; and the principal amount can be repaid when the loan tenor comes to an end, thereby minimising the EMIs.

Types of EMI Payments

There are two types of EMI Payments — EMI in Arrears or Standard EMI. EMI in Arrears is where the borrower must pay the EMI at every month-end over a definite loan tenure in order to repay the borrowed loan. In such a scenario, the total principal loan amount (the processing fee is deducted) is disbursed by the lender, to the bank account of the borrower, without any advance EMI payment deduction. This scheme is perfect for those who do not have enough funds for a down payment.

Advance EMIs are offered by numerous banks wherein the first EMI payment will be paid to the bank in advance, and the principal amount (after deducting the processing fee along with the 1st EMI amount) will be disbursed to the bank account of the borrower. In such a scenario, this advance EMI paid, doesn’t consist of the interest payment, but, only the principal amount. This way, the principal loan amount is reduced for the rest of the EMI payments.

Methods of Calculating an EMI

EMI can be calculated in two ways: The flat-rate method and reducing balance interest method.

Flat-rate method

Under this method, the interest is levied on the whole loan amount irrespective of any principal amount already repaid. This method is usually used by lenders of vehicle loans.

The formula for this method is:

EMI = (Principal + Interest)/Period in Months

For instance, if you intend to buy a vehicle and opt for a loan of Rs.2 lakhs that comes at a 12% rate of interest and a tenure of 2 years, as per the flat rate method, the interest will be calculated on the full loan amount of Rs.2 lakhs.

Hence, in this example, the calculation of the EMI would be:

EMI = (200000 + 48000)/24 = Rs.10,333.33

Reducing balance interest method

Under this method, the interest is levied on the outstanding balance of your loan amount post monthly repayment of the principal amount. In such a scenario, the  EMIs will see no change, however, there will be a reduction in the interest amount every month. This method is usually used by lenders of personal loans.

The formula for this method of EMI calculation is:

EMI = [P x R x (1+R)^N]/[{(1+R)^N}-1]

Where,

P = Principal Loan Amount

R = monthly rate of interest

N = duration of the loan in months

So, if we take the same example mentioned in the previous method, the calculation of EMI would be:

EMI = [200000 x 12/(100 * 12) x (1.01)^24] / [{{1.01)^24}-1]

= 2000 x 1.2697 / 0.2697

= Rs. 9415.65

Credit Card EMIs – How are they deducted?

Credit cards are the most convenient way of making payments these days and they also offer the EMI scheme of payment. So, how are the EMI’s deducted from your credit card?

Once you make a purchase on your credit card and opt for the EMI option, the available credit limit of your credit card gets reduced by that specific amount of purchase made by you towards the particular goods or service.

The credit card EMI works similar to that of a personal or home loan, wherein the borrower will be paying the principal as well as interest every single month, thereby reducing their debts gradually till the loan is completely cleared off. The reduce-balance method is used to calculate the EMI’s.

Factors that impact the calculation of an EMI

The EMI is computed taking into consideration three main factors which are as follows:

Loan Amount: This is the main factor determining the EMI and it refers to the amount borrowed by an individual. The EMI is directly correlated to the size of the loan; i.e., the higher your Lon amount, the greater will be your EMI.
Interest Rate: The interest rate of a loan is computed by considering multiple factors such as the borrower’s income,  credit rating, borrowing history, the current market scenario, the ability to repay, etc. This is a crucial element that has an impact on the EMI.

The Tenor: The third most important factor is the tenor or duration of the loan. If you opt for a loan spread out over a long tenor, the EMI would be lower in contrast to that of a short tenor. However, be aware that if the tenor is long, the interest outgo would be higher.

Conclusion

An EMI cannot be confined to a good or bad image, and this totally depends on the borrower. If you are someone who is particular about repaying all the dues on time, a loan EMI wouldn’t be as bad as it would be for those who accumulate bad debts. EMI’s are quite helpful to borrowers as the debt gets divided and the borrower can budget their income and expenses well and fix their EMI payments every month. The borrowers are well aware of the amount to be repaid, the duration of the loan, etc. In case you want to get rid of the “EMI Traps” all you need is simple planning and budgeting. However, if that loan is necessary to meet your personal goals, do not forget to research the financial institution offering the loan, understand how the interest rate is calculated, and what would be the total amount you would end up repaying.