Unlocking the Math: How is Your Loan EMI Calculated?

Bankers often confuse you with terms like 'Reducing Balance' and 'Amortization Schedule'. We break down the EMI calculation into simple terms.

By Finance Editor•Updated: 27 January 2024

When you take a loan, you agree to pay it back in monthly installments. But have you ever noticed that even after paying for 5 years, your loan balance hardly seems to drop? That is because of the way EMI (Equated Monthly Installment) is structured.

1. The Formula

The universal formula used by all banks for Home, Car, and Personal loans is:

EMI = [P x R x (1+R)^N] / [(1+R)^N - 1]

Where:

  • P: Principal Loan Amount
  • R: Monthly Interest Rate (Annual Rate / 12 / 100)
  • N: Loan Tenure in Months

2. Reducing Balance vs Flat Rate Method

This is the most critical distinction to understand before signing a loan agreement.

Reducing Balance (Good)

Interest is charged only on the outstanding principal. As you pay EMIs, the principal reduces, and so does the interest for the next month. This is the standard for Home and Car Loans.

Flat Rate (Bad)

Interest is charged on the entire principal for the entire tenure, even though you are paying it back.

Warning: Many NBFCs and "0% EMI" schemes use the Flat Rate method. A 10% Flat Rate is roughly equivalent to an 18-19% Reducing Balance Rate! Always ask the lender for the APR (Annualized Percentage Rate).

3. The Amortization Schedule (The Magic Table)

Let's take an example: Home Loan of ₹50 Lakhs @ 8.5% for 20 Years.
EMI = ₹43,391.

Month 1 Breakdown:

  • EMI Paid: ₹43,391
  • Interest Component: ₹35,416 (approx 81% of EMI!)
  • Principal Repayment: ₹7,975 (only 19%)

Month 120 (After 10 Years) Breakdown:

  • EMI Paid: ₹43,391
  • Interest Component: ₹24,800
  • Principal Repayment: ₹18,591

This explains why prepaying early in the loan tenure is so effective. If you prepay ₹1 Lakh in the first year, you save interest on that ₹1 Lakh for the next 19 years!

4. Smart Ways to Reduce Loan Burden

  1. 1 Extra EMI per Year: Just paying one additional EMI every year can reduce a 20-year loan to approx 16 years.
  2. Increase EMI with Salary: If your income grows by 10%, increase your EMI by 5%. This drastic reduction in tenure saves lakhs in interest.
  3. Round Up: If your EMI is ₹23,450, round it up to ₹25,000. The small difference hits the principal directly.

Conclusion

EMI is not just a payment; it's a financial instrument. Understanding how it works empowers you to negotiate better rates and plan your prepayments strategically.

Check your loan schedule now with our EMI Calculator.

Frequently Asked Questions

Does EMI amount remain constant?

Yes, 'Equated' means equal. However, the proportion of interest vs principal inside that EMI changes every month.

Why is interest so high in the initial years?

Interest is calculated on the outstanding balance. Since the balance is highest at the start, the interest component is huge. As you pay off principal, interest reduces.

What is Pre-EMI?

For under-construction properties, banks may ask you to pay only the interest portion on the disbursed amount until possession. This is called Pre-EMI.