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Here’s how your bank calculates your monthly EMI

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Here’s how your bank calculates your monthly EMI

The Equated Monthly Installment or EMI is a word that has immense importance in our lives today. In modern times, loans have become the tickets towards aspirational purchases like a new home and cars while also helping us meet life goals. Several people have multiple loans in their personal portfolio and hence the EMI (equated monthly installment) payment takes out a large chunk of their monthly income and expenditure, particularly if there is a home loan being repaid.

While you’re repaying the EMI for your loans diligently (you should never skip repayment or forget to pay within the due date), have you ever wondered how the monthly EMI is calculated by your bank? The answer is more likely to be a NO than a resounding yes. As a result, you should make it a point to learn more about the calculation process, important variables and factors which come into the mix and other vital information related to loan EMIs. EMI includes both the principal portion and also the interest portion. In the initial years, the former is lesser than the latter which is worked out on the outstanding balance from the principal amount which is due.

Calculation methods and other vital details

The daily reducing balance method is what is used by banks in case of home loans and the monthly method is used by some companies in the housing finance space too. Banks charge interest via three ways, namely annual reducing, monthly reducing and daily reducing balance. The latter is the method used for home loans as mentioned. Under this system, the principal amount keeps reducing with every EMI payment. Yet, since the EMI amount is paid on a monthly basis, there will be no difference in the effective rate of interest unless you make periodic prepayments.

If you are making a prepayment, the principal outstanding will be lowered on the day of the part prepayment that you make. Suppose you repay your monthly EMI on the 5th of each month and then make a prepayment on the 10th of the month. In this scenario, in the daily mechanism, the principal outstanding will go down instantly. In the monthly system, prepayment will be considered on the 5th of the next month. The repayment of your loan throughout the whole duration/tenor is displayed via the loan amortization schedule. This is a tabular representation of the entire principal and interest being paid by you and also the principal outstanding at the end of each month.

How do banks work out the EMI amount?

The EMI is dependent on three vital aspects, namely the interest rate, the loan amount and also the tenor of the loan. The EMI for the loan can be easily worked out on the basis of the PMT formula in Excel. You will thus require three chief variables, namely the rate of interest, the period of the loan and also the present value of the loan or the loan amount. The rate of interest will have to be taken as the monthly interest rate since you pay your EMIs on a monthly basis.

Suppose if the rate of interest is 12% then you will have to divide the same by 12, i.e. 1% on a monthly basis. Now, the tenor/period of the loan has to be taken into account. Suppose it is 20 years or around 240 months. Now, let us assume that your loan amount is Rs. 40 lakh for buying your own home. If the interest rate is 12% and the tenor of the loan is 20 years, then the EMI amount payable will be Rs. 44,043 and the total interest payable on the loan will be Rs. 65,70,427.

Alternatively, you can always go for this particular formula for calculating the loan EMI- P*R*((1+R)^n)/(1-(1+R)^n). Here, R is the monthly interest rate and P is the principal outstanding while n is the number of monthly installments payable for the loan. This is a handy formula that banks use for working out the final EMI amount on your loan. If you already have a home loan or any other loan running, you should endeavor to find out the calculation method while also knowing more about the interest that is ultimately payable.

You can use online EMI calculators in this regard. Once you know more about the total interest amount payable, try and reduce the same by making periodic prepayments for your loan whenever you have surplus funds in hand. This will help you cut down on interest payment and save more money in the bargain. Make sure that you keep repaying your home loan in a disciplined manner without missing payments since that will affect your CIBIL score. If you are already on a floating rate home loan, you can consider a switch to the repo-rate linked home loan system if that will lower your interest rates and monthly home loan EMIs. However, take a step only after carefully evaluating your savings and gains and also consulting bank officials.

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