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Understanding the Concept of EMI!

February 23, 2012 | Comments: 0 | Views: 179

EMI (Equated Monthly Installment) is a very commonly used term in personal finance, thanks to the plethora of loan options that are available for people who wish to borrow money! Though many of you shell out money with regularity for the EMI of a loan you have opted for, have you figured out how it is calculated? Do you know the exact ratio of the principal and interest that is present?

If you know relevant answers for the above queries, you will be in a better position to manage your loan more efficiently. For instance, you will understand the power of pre-payment and how it can reduce your total interest cost of the loan. Let us understand EMI better through this article to help you make informed decisions.

What exactly is an EMI and how it needs to be paid?

EMI is an acronym for an Equated Monthly Installment, which is actually the money paid back on a monthly basis to the lender. The term 'equated' indicates that the monthly sum repaid is always equal and fixed, and the borrower repays it to the lender at a particular date every month.

An EMI consists of 2 parts - the principal sum + the interest on the principal sum. The payable amount is a ratio of both these components, which gets repaid over an estimated number of years until the loan repayment is complete. As a borrower keeps paying it, the outstanding payable loan amount decreases every month, until it becomes NIL, when the full amount of the principal and the interest is paid off.

During the initial years of the loan repayment period, the interest portion of the loan forms the larger pie of the ratio and this situation becomes reversed as the tenure progresses. Towards the latter half of the loan repayment period, the principal portion of the ratio is higher. This goes on till the end of the loan tenure, in the final stages of which, the interest becomes negligible.

An EMI is calculated on the basis of the total loan amount, the interest rate and the loan tenure. It is paid through post dated cheques that are addressed in favour of the lender, beforehand.

How does it work for different loan types?

Although an EMI is always estimated to be 'equal' monthly payments that combine the principal and the interest of a loan, it can be different for different types of loans. For instance, in a personal loan, it works in the same way as it does in a home loan. In both these forms it is determined as equated monthly installments of a fixed sum of money borrowed. For a gold loan however, it could include only the interest on a monthly basis, followed by a lump sum payment of the principal amount at the end of the loan tenure.

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Source: EzineArticles
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