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Understanding Equated Monthly Installment – What is an EMI?

 

We all keep hearing about EMI, and most of us also pay EMIs for various loans. But what exactly is an EMI? What is its breakup? If you have to prepay a loan, whan should you do it? Let’s understand.

Once upon a time, we used to purchase houses using home loans, and paid an Equated Monthly Installment (EMI). But today, many desirable things are available with “easy-EMIs” – this includes laptops, LCD TVs, foreign holidays, and more.

We happily purchase these products on loan, and pay EMIs. But do we know what an EMI is? What its components are?

 

What is an Equated Monthly Installment (EMI)?

Any loan today is repaid in equal monthly amounts, which are called Equated Monthly Installments or EMIs.

The EMI depends on the loan amount, the rate of interest and the duration or the time of repayment of loan.

 

The Components of Equated Monthly Installment (EMI)

 

Components Of EMI

Components Of EMI

 

The EMI consists of two portions – the principal amount, and the interest on the loan.

Through the principal portion of the EMI, you repay the loan in small bits every month. Thus, the outstanding loan amount (or the remaining loan amount) reduces every month by this amount.

Through the interest portion of the EMI, you pay the bank the interest on the outstanding loan amount.

When the loan starts, the interest component is very large, and the principal component is very small. Every month, the interest component becomes smaller than the previous month, and the principal component becomes larger than the previous month.

 

EMI Over Time

EMI Over Time

 

Over time, the principal component becomes larger than the interest component, and towards the end of the tenure of the home loan, the interest component becomes negligible.

 

When should you prepay a loan?

With this understanding, can we decide when is the best time to prepay a loan? This question is quite relevant for home loans, as the amounts (and thus, the interest) involved is very large.

Towards the end of a loan, we are mostly paying the principal and very little of interest.

Whereas towards the beginning of a loan, we are mostly paying interest, and very little in terms of repaying the principal.

Therefore, if we repay the loan towards the beginning, we would be saving a lot more on the interest than if we repay the loan towards its end.

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