EMI: Meaning, How It Works, Calculation Method, Benefits & Drawbacks

EMIs have become one of the most common forms of payment for any financial obligation, from college fees to purchasing a new phone. This fixed monthly amount saves lakhs of citizens annually by preventing sudden financial setbacks and helping people fulfil their desires. Understanding the concept of EMIs and their formula is very important in the modern world. It is the first step towards maintaining a positive credit score and making budgeting more manageable.

What Is EMI?

An EMI, an equated monthly instalment, is a fixed/ variable amount the borrower owes monthly to the lender. This setup can relate to any loan from any financial institution, which you will repay slowly in smaller instalments. It includes the principal loan amount and a certain interest applicable on that lump sum of money for the overall tenure of the loan. Examples include vehicle and student loans, which can take years to close until you repay the principal amount. 

How is an EMI Payment Different From a Down Payment? 

EMI payment and Down Payment are two different types of financial tools that help in purchasing many expensive items that might require long-term loans and significantly improve the buyer’s lifestyle. 

How Does EMI Work?

EMI and its interest rate are the basic structures that support multiple industries, such as housing loans and credit car payments. EMI is dependent on various factors, like: 

• Loan Amount: The higher the loan amount, the Higher the value of the EMI payment 
• Duration of loan: The higher the loan duration, the smaller the monthly EMI payments 
• Rate of interest: A higher rate of interest leads to high EMI payments 
• Risk Intake of The Lender: Lower credit score of the borrower leads to higher interest rates every month, hence high EMI values
• Down Payment: A high down payment leads to lower monthly EMIs, reducing the overall principal loan payment 

If a bank lends money to a borrower, it charges minimal interest every month because it is taking a risk by providing them with a lump sum payment. Sometimes, banks support this payment with a collateral security. 

EMI Calculation with Example 

Rahul lends Sunita 4000 rupees for a video game, which she will pay within four months at a set interest rate of 5%, directly from her pocket money. So, Sunita’s monthly EMI payments will be as follows: 

• Principal Amount / 4 = INR 1000 
• Monthly Interest = 5% of 4000 = INR 200

EMI= Principal Amount of the Month+ Interest of the month 

Which is INR  1000 + 200 

So, Sunita will pay INR 1200 monthly to Rahul to give closure to her EMI payments. 

Now, if Sunita had asked for a loan extension of up to 6 months for any reason, 

Her monthly principal payments would have been 4000/6= 666.667

• Given the fixed interest rate on the loan amount, interest would have still cost her INR 200. 
• So, her monthly EMI payments would have been INR 667+ 200 = INR 867 for six months. 
• This EMI might look smaller than the four-month payment of INR 1200, but here is the trick.
• Sunita’s total interest for four months was INR 800, but it cost her INR 1200 for six months. Hence, shorter-duration loans are better than longer ones.

Now, let’s imagine another scenario where Sunita gave Rahul INR 500, which she received from a guest on the first day of the loan, as a gift for helping her.

The loan amount remains 3500, so the principal monthly payment is 3500 / 4 = INR 875.

So the monthly EMI payments would be INR 875 interest on the month-

INR 875+ 200= INR 1075

Hence, lower loan amounts for a similar duration lead to fewer monthly EMI payments.

Benefits and Drawbacks of EMI

Here are some of the pros and cons of choosing EMI payment as a financial tool for purchasing products/ services:

Documents Required for EMI

Banks require documents and identity proofs to allot loans and start EMI payments for various purchases. These help prove your repayment capability and ensure that you have a stable job/ source of income.

Some of them include: 

• Identity Proof like PAN Card, Voter ID Card, Passport, Aadhaar Card and Driver’s License
• Address Proof like Rental Agreement, Voter ID Card, Passport, Rental Agreement, Electricity Bill, Water Bill, Property Tax Receipt 
• Income Proof like Form 16, Employment Letter, Offer Letter, three months’ salary slips, bank statements and ITR forms 
• Employment Proof like Company ID Card, Employment Verification Letter and Offer Letter 
• Business Proof like Registration Certificates, Bank Statements, Income Tax Returns and Profit & Loss Statement
• Loan Related Documents like Application Forms, Property Proof and Proforma Invoice 
• 2 Passport Size photographs 
• Cancelled Bank Cheque and Signature Proof 
• Guarantor Form and Post-Dated Cheques

What is the Difference Between EMI in Advance and EMI in Arrear?

EMI payments can become a budgeting issue if not handled properly, as they might go on for years and have a high interest rate. This reason is why it is very important to know the two different types of EMI Payments:

Tips for Managing EMI

Here are some essential tips to manage EMI payments and interest rates-

• Do Your Homework: Before choosing a home loan, compare different lenders’ interest rates and repayment plans. Look for the lowest interest rate that fits your financial plan. It’s worth the effort upfront to save money in the long run.
• Keep an Eye on Your Income: Lenders like steady incomes, as they reassure them that you’ll be able to repay the loan within the set timeframe. Try to keep your EMIs only a small percentage of your net income, and try not to keep other debt, as this keeps things manageable.
• Don’t Miss a Payment: Late payments can lead to extra fees and make your loan even more expensive. If you’re ever struggling to pay, immediately contact your lender for an extension, even if it requires your interest rate to surge. They might have options to help you so you don’t mess up your credit score. 
• Increase Your EMI Over Time: A smart move is to increase your EMI by a small percentage each year. If your salary increases or you get a bonus, this is a great way to pay off your loan faster and save on interest, given your bank does not have any pre-payment charges. 
• Use an EMI Calculator: An EMI calculator is a handy online tool that shows you exactly what your monthly payments will be. It’s a great way to determine the best loan option based on income and expenses. 
• Make Partial Payments: Make extra payments on your loan whenever you can. This payment reduces your EMI burden over time. It’s a great use for any additional income or bonuses you receive, ensuring that you pay off the loan well on time and that you won’t have to sacrifice your entire month’s salary. 
• Consider Extending the Loan Tenure: If you face financial challenges, you can extend your loan tenure. This step will lower your monthly EMI, making it easier to manage your budget until things improve.

Common EMI Mistakes to Avoid

Here are some of the common EMI mistakes that borrowers make which increase their interest and monthly payments:

Ignoring the EMI Budget

You should approach EMIs as a monthly expense, as you would budget for groceries, utilities, or other bills.  Including the EMI amount in your monthly budget is critical to prevent skipping payments, which could lower your credit score. Prioritise your monthly essentials to remain on top of your finances and ensure you can manage the repayments with your current income. 

Overdue or Unpaid EMI Payments

If you are on a salary, plan your EMI payment date right after your money is credited. This step will help you save your face for unpaid EMIs and prevent overlap between savings and current accounts.

Choosing Longer Repayment Tenures

Opting for a long repayment period has the downside of increased interest over time, but it also lowers your monthly EMI. This helps you make feasible payments every month on time without suffering financial setbacks and delayed EMI instalments. 

Not Comparing Loan Offers

Comparing different lenders having varying interest rates, repayment policies, and terms is one of the wisest financial decisions you can make. You can secure a loan with attractive interest rates and flexible repayment options within your monthly budget. 

Ignoring Prepayment Opportunities

Many lenders allow borrowers to prepay their loans without any extra charges, which can reduce their overall financial burden. Prepaying loans can lower the total interest paid and significantly reduce the repayment period. However, lenders might impose some penalties on the borrower in case of full repayment of the loan, which will be mentioned in the terms and conditions. 

Conclusion

In conclusion, an Equated Monthly Installment (EMI) is a crucial financial concept that plays a significant role in personal and business finance. Understanding the calculation process of EMI is important for planning finances and comparing different loan offers. Borrowers can apply for the most suitable repayment schedule that aligns with their long-term and short-term financial goals. Hence, having a clear grasp of EMI helps maintain financial discipline and avoid any pitfalls of EMI management. 

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