EMI calculators are available on almost every bank website that offers home loans, but do you know how they work?
Most people have multiple loans these days. As a result, borrowers tend to spend a significant portion of their monthly incomes on their equated monthly instalment (EMI) payments. Despite this, few of them take the time to find out how banks arrive at their EMI numbers.
So, let's see how EMIs are calculated:
For home loans, banks charge interest in three different ways - daily reducing, monthly reducing, and annual reducing balance. Some housing finance companies use a monthly method, while banks use a daily reducing balance.
Daily payments reduce the principal on the day of payment. In any case, EMI is paid monthly, so the effective interest rate is unchanged, unless the borrower prepays, said Abhinav Angirish, Founder, Investonline.in while talking to CNBC-TV18.com.
"When borrowers make partial prepayments, their outstanding principal will be reduced on that day. With the daily method, if they pay the EMI on the fifth of every month and make a prepayment on the 10th, the principal outstanding will be reduced immediately. The prepayment would be taken on the fifth of the following month if the monthly method is used," he said.
The loan amortisation schedules show how much interest and principal borrowers pay at the end of each month as well as the outstanding principal.
How does a home loan calculator work?
By using a home loan calculator (that is available online across platforms), borrowers can estimate the affordability of mortgage. It is important to understand that the EMIs for a home loan are set up according to the cash flow of an individual, according to Angirish.
"The principal amount of the loan, the interest rate and the term of the loan are the inputs required to calculate EMIs for a home loan. It is recommended that between 35 percent and 45 percent of the income be used to repay the loan, with the remainder going towards maintaining a balanced lifestyle. Families, however, have different needs and this percentage varies accordingly," he told CNBC-TV18.com.
The EMI calculator calculates monthly instalments using a mathematical formula.
The formula is: EMI = P x I x (1+I) ^T]/
P is the principal loan amount
I is the monthly interest rate
T is the number of total monthly instalments
Note: Monthly interest rates are calculated by dividing the annual interest rate by 12 and multiplying it by 100.
EMI calculators make the calculation easier. All you need to do is enter the desired inputs, which are:
Input: Principal amount, tenor of loan and rate of interest
Output: Total number of EMIs and amount of each monthly EMI