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Love them, hate them, but you can't ignore them. Enter loans, to fill in the gap between wants and means. And they come in myriad forms - home loans, auto loans, consumer durable loans and so on.
Along with loans, comes EMI (equated monthly instalments), which especially in the case of big ticket loans, could be quite substantial. So, knowing the basic math behind EMIs may hold you in good stead.
EMI is a fixed amount paid by the borrower to the lender, every month, over the tenure of the loan. For example, if you borrow Rs 1,00,000 at an interest rate of 10 per cent per annum for a period 3 years, the EMI works out to Rs 3,227. This means for the next 36 months, you will have to pay the lender Rs 3,227 each month. EMI depends on the principal (loan amount), interest rate and loan tenure. The higher the principal and the interest rate, the higher the EMI. On the other hand, the higher the tenure, the lower the EMI. But a longer tenure would also entail higher total interest outgo. Hence, if you can afford a higher EMI, go for a shorter tenure and save on interest.
Divergent ways
In the example above, the total amount paid by the borrower over the tenure works out to Rs 1,16,612. The excess amount (Rs 16,612) over the principal (Rs 1,00,000) constitutes the interest on the loan. Each EMI comprises of two components – principal and interest. Although the EMI is the same for all the months over the tenure of the loan, the ratio of principal and interest vary in each instalment. The proportion of interest is higher in the initial EMIs than in the later ones. Towards the end of the loan, interest constitutes only a minor portion of the EMI. For instance, in the example above, the first EMI of Rs 3,327 is made up of interest of Rs 834 (around 26 per cent) and principal of Rs 2,393 (around 74 per cent). By the time, the last (36th) instalment is paid, interest reduces to Rs 27 (0.8 per cent), while the principal component increases to Rs 3,200 (99.2 per cent).
The principal and interest components of the EMI move in opposite directions because interest on each EMI is calculated on principal that is outstanding just before that instalment. For instance, in the first EMI in the above example, interest is calculated on the entire outstanding principal amount of Rs 1,00,000. However, in the second instalment, the principal of Rs 2,393 already paid in the first instalment is excluded, and interest is calculated on the reduced principal of Rs 97,607. This process continues, resulting in a miniscule interest and high principal component by the time of the last EMI.
So what does this mean for a borrower in practical terms? In case you intend to prepay the loan, it makes more sense to do so in the initial stages. Any prepayment is adjusted against outstanding principal. As a result, prepayment in the initial stages sharply reduces future interest outgo. On the other hand, when you prepay in the later stages, the benefit is lesser since bulk of the interest would already have been paid.
Rest
Borrowers should also note the method used by the lender to calculate the outstanding principal – whether it is on daily reducing, monthly reducing, or annual reducing basis. The frequency of calculation of outstanding principal is known as ‘rest'. The more frequent the rest, the more beneficial it is for the borrower. That is, daily rest is better than monthly rest which in turn scores over annual rest.
Here's why. In annual rest, although you pay the EMI on a monthly basis, the principal outstanding is considered to be the same till the end of the year. Hence, for the balance period of the year, you continue to pay interest on principal which has already been repaid. Clearly, a raw deal for the borrower. In monthly rest, the principal outstanding is reduced at the end of the month when the EMI is paid. A daily rest basis is most beneficial for borrowers, since the outstanding principal balance is reduced on the same day of payment. The benefit of daily rest over monthly rest is apparent when the borrower makes prepayment between the dates of EMIs.
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