Definition
An Equated Monthly Installment (EMI) is the fixed payment that borrowers make to lenders on a monthly basis. The EMI consists of two parts: interest and principal. Once you have paid a certain number of equal monthly installments, your loan will be fully repaid.
Definition and Examples of EMI
An Equated Monthly Installment is a fixed monthly payment that borrowers make to lenders, typically on the same day of each month. You can use it to repay a variety of loans, including mortgages, car loans, and student loans. As long as you adhere to the schedule of equal monthly installments, you will be able to repay your loan in full by the end of the term.
Unlike variable payment plans that allow borrowers the flexibility to make payments at any time they wish based on their financial situation, equal monthly installments have a clear repayment schedule and duration for completion. The EMI is ideal if you want to plan your loan and know exactly what you will pay upfront.
How EMI Works
The equated monthly installment includes both principal and interest, along with the loan tenure. The value of each monthly payment will depend on the loan amount, its term, and the interest rate. When you make the initial payments, most of the amount will go towards interest. Over time, you will be paying more towards the principal repayment.
There are two methods to calculate the equated monthly installment: the declining balance method and the flat rate method. With the declining balance EMI, the interest is based on the outstanding principal amount and allows for lower interest payments over time. The flat rate EMI looks at the original loan amount to calculate interest.
It’s worth mentioning that the flat rate method disregards the loan balance, leading to higher total interest payments than the declining balance EMI. For this reason, the declining balance method is generally considered more cost-effective and appealing to borrowers.
Flat Rate Method
To calculate the equated monthly installment using the flat rate method, you first need to sum up the total principal of the loan and the total interest on the principal together. Then, you should divide the sum by the total number of payments, or the number of months over the loan tenure.
Suppose you took a loan of $50,000 at an interest rate of 4% for two years. Using the flat rate EMI, you would incur a total interest amount of $4,000 or about $166 per month. Your EMI payments would be $2,250 monthly. Flat rate equal monthly installments are widely seen in car loans and personal loans.
Declining Balance Method
The calculation of the equated monthly installment through the declining balance method looks like this:
EMI = 50,000 × (0.04/12) × [(1+(0.04/12))24] / [(1+(0.04/12))24-1] = $2,171.25
Using this calculation, your EMI payment would amount to $2,171.25 monthly. In this case, the principal amount paid is deducted from the remaining loan amount, and interest for the subsequent year is charged on the remaining deducted balance. It is not deducted from the total loan amount, as in the case of the flat rate method. As mentioned, the declining balance method is usually preferred, as it is considered more cost-effective than the flat rate method, which often leads to a higher interest rate. You will typically see declining balance equal monthly installments in mortgages or credit cards.
Takeaways
– An equated monthly installment is the fixed monthly payment that a borrower makes to the lender.
– Equal monthly installments are used to repay a variety of loans including mortgages, car loans, student loans, and personal loans.
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The equal monthly installment consists of two parts: principal and interest.
– You can use the fixed-rate method or the declining balance method to calculate the equal monthly installment.
Source: https://www.thebalancemoney.com/what-is-an-equated-monthly-installment-emi-5193425
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