Khota Paisa

All You Wanted to Know About Loans!

Posted in General by khotapaisa on June 4, 2009

Whenever we discuss loan, the first things that comes up is the EMI(Equal/equated Monthly Installment). Ever wondered how this is calculated? If you try to google on this subject, you will get a complex formula to calculate the EMI. Well, lets try to understand how EMI is calculated.

EMI Calculation –
Let say you take a loan of Rs.100,000/- at 10% rate of interest. It simply means that every year you will pay 10% interest on the principal amount. You will also pay a fixed monthly amount towards the principal. How much each of these two will be? Let’s try to calculate.
Loan = 100000/-
Tenure = 5 years
Rate = 9%
Interest you need to pay for full year = 100000*9% = 9000/-
Monthly interest payment = yearly payment / 12 = 9000 / 12 = 750/-
So, every month you contribute 750/- towards the interest.
For principal, you need to pay a fixed amount every month such that it grows to 100000/-(loan amount) after 5 yrs(loan tenure) while earning 9%(our loan rate) interest on it. You can calculate it using MS Excel(PMT() function). This comes out to be 1326/-. So, you need to pay 1326/- per month so that you can pay 100000/- of principal amount in 5 years.
Now, add the two components (payment towards interest + payment towards principal) and you get your EMI as 1326+750=2076/-.
Amortization –
Nnow that the term EMI is clear, lets look at another term amortization or amortization schedule. Remember calling up your bank to get details of interest and principal payment for the year to get tax calculations. It’s the amortization schedule that the bank gives you. Basically it is breakup of youe EMI into interest and principal components for each month. The concept till now was simple. Every month you pay a fixed amount towards interest and principal each. But since your interest component is only based on the principal remaining, the breakup of your EMI changes every month depending on the principal left to pay till date. In this case, for the first month, the interest component of the EMI will be 750 and the remaining part of EMI(i.e. 1326/-) will be the principal component. Next month your interest will be charged on reduced principal(100000 – 1326). So, the interest payment will go down a little(you just paid 1326/- towards principal last month!) and hence the principal component will go up. So to find out the break up the EMI every month, you calculate the total principal paid till date. Then you calculate the interest component on the remaining principal. This will be the interest part of your EMI. The remaining part of the EMI goes towards the principal payment. See the example below.
Prepayment –
Now that you know all about your EMI & amortization schedule, let’s try to untangle the web of prepayment(rather partial prepayment). How does it reduce the no. of EMI to be pai?. As per loan contract, you are bound to pay EMI every month. But you may pay extra amount if you wish. We can call it kind of “top-up”. Every top-up(partial prepayment) you make, goes solely towards reducing your principal amount. And since the interest component of your next EMI is calculated on the unpaid principal, the top-up actually reduces the interest component. In doing so, it also increase the principal component of the EMI. So, every time you make a pre-payment, your interest component of EMI reduces further & principal component increases, allowing for an early payment of the loan. That means the no. of EMI you pay get reduced. Refer to the image above. Say, you make a prepayment of 1000/- in the first month. The interest component of the next EMI will be calculated on the remaining pricipal i.e 100000-1326-1000=97674/-. So, in the second month, your interest component wil be ~732/- against 740/-.
Here is a thumb rule to find out how many less EMI you will have to pay if you make a prepayment.
Less EMIs = (no-of-EMIs-left/36) x (prepayment-amount / EMI).

Whenever you discuss loan, the first things that comes up is the EMI(Equal/equated Monthly Installment). Ever wondered how this is calculated? If you try to google on this subject, you will get a complex formula to calculate the EMI. Well, lets try to understand the EMI calculation first.

EMI Calculation

Let say you take a loan of Rs.100,000/- at 10% rate of interest. It simply means that every year you will pay 10% interest on the principal amount. You will also pay a fixed monthly amount towards the principal. How much each of these two will be? Let’s try to calculate.

Loan = 100000/-

Tenure = 5 years

Rate = 9%

Interest you need to pay for full year = 100000*9% = 9000/-

Monthly interest payment = yearly payment / 12 = 9000 / 12 = 750/-

So, every month you contribute 750/- towards the interest.

For principal, you need to pay a fixed amount every month such that it grows to 100000/-(loan amount) after 5 yrs(loan tenure) while earning 9%(our loan rate) interest on it. You can calculate it using MS Excel(PMT() function). This comes out to be 1326/-. So, you need to pay 1326/- per month so that you can pay 100000/- of principal amount in 5 years.

Now, add the two components (payment towards interest + payment towards principal) and you get your EMI as 1326+750=2076/-.

Amortization

Now that the term EMI is clear, lets look at another term amortization or amortization schedule. Remember calling up your bank to get details of interest and principal payment for the year to get tax calculations? It’s the amortization schedule that the bank gives you. Basically it is breakup of your EMI into interest and principal components for each month.

The concept of EMI explained above was simple. Every month you pay a fixed amount towards both interest and principal. But since your interest component is only based on the principal remaining, the breakup of your EMI changes every month depending on the principal left to pay till date. In this case, for the first month, the interest component of the EMI will be 750 (=100000*9%/12) and the remaining part of EMI(i.e. 1326/-) will be the principal component. Next month your interest will be charged on reduced principal(100000 – 1326). So, the interest payment will go down a little(you just paid 1326/- towards principal last month!) and hence the principal component of the EMI will go up. So, to find out the break up the EMI every month, you calculate the total principal paid till date. Then you calculate the interest component on the remaining principal. This will be the interest part of your EMI. The remaining part of the EMI goes towards the principal payment. See the example below.

emi

 

Prepayment

Now that you know all about your EMI & amortization schedule, let’s try to untangle the web of prepayment(rather partial prepayment). How does it reduce the no. of EMI to be pai?. As per loan contract, you are bound to pay EMI every month. But you may pay extra amount if you wish. We can call it kind of “top-up”. Every top-up(partial prepayment) you make, goes solely towards reducing your principal amount. And since the interest component of your next EMI is calculated on the unpaid principal, the top-up actually reduces the interest component. In doing so, it also increase the principal component of the EMI. So, every time you make a pre-payment, your interest component of EMI reduces further & principal component increases, allowing for an early payment of the loan. That means the no. of EMI you pay get reduced. Refer to the image above. Say, you make a prepayment of 1000/- in the first month. The interest component of the next EMI will be calculated on the remaining pricipal i.e 100000-1326-1000=97674/-. So, in the second month, your interest component wil be ~732/- against 740/-.

Here is a thumb rule to find out how many less EMI you will have to pay if you make a prepayment.

Less EMIs = (no-of-EMIs-left/36) x (prepayment-amount / EMI).

So, if you making a prepayment of 10000/- on a EMI of 2000/- at a time when you have say 120 EMIs (10 years) left to pay, you will end up reducing your total EMIS by rougly(120/36)x(10000/2000) = 16(i.e 1.25 yrs knocked off your loan duration).

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