Saturday, January 12, 2008

How EMI or EAI works with Home Loan

This is one acronym that is now synonymous with the loan business. "What is EMI?" and "How is it calculated?" are two of the most common questions put forth by loan applicants.

The EMI is an abbreviated form of the Equated Monthly Installment and is simply referred to as monthly installment in common parlance. And, being a self-explanatory term, that is exactly what it is. The amount you will have to pay your financier every month when repaying your loan.

Being a monthly payment, at the end of the year, you would have paid 12 EMIs. This is sometimes referred to as the equated annual installment (EAI) - the amount you would pay every year.

Let's explain it with the following figures:

Loan amount: Rs 1 lakh
Repayment tenure: 5 years
Rate of interest: 10.50% per annum
Calculation of interest: Annual reducing basis
The EMI works out to be Rs 2,226
Hence, the EAI will amount to Rs 26,712 (2,226 x 12).

However, it is important to note that though the EMI is a constant amount throughout the repayment tenure, in actuality it is an unequal combination of principal repayment and interest payment. This unequal distribution is due to the EMI tilting heavily towards interest payments in the initial years of repayment. While principal repayments take predominance as the end of the repayment tenure nears. For instance, in the above example, the EMI will stay constant for all the 60 months at Rs 2,226. However, in the first year of repayment, only Rs 16,218 of the principal is repaid and in the final (fifth) year, Rs 24,179 of the same.

How to arrive at the right EMI ?

From a purely mathematical point of view, a financier will calculate the EMI taking into account four factors: The principal (the actual loan amount) The repayment period (the number of years you will take to repay the loan) The annual rate of interest How the rate of interest is computed (monthly or annual reducing basis).

However, the EMI that is finalised upon will also depend on your comfort level and repayment capacity. For instance, if the EMI arrived upon (based on the above criteria) puts a fair amount of financial stress on you, you can talk to a housing finance officer and ask for an extended repayment period and, hence, a lower EMI.

On the other hand, you may find the repayment tenure fairly long while the EMI does not put any financial strain on you whatsoever. You can then request for a lower repayment tenure and an increased EMI.

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