If you’ve ever taken out a loan or planning to take a loan, you know that you have to pay back more than just the amount you borrowed. This is because the lender or Bank charges you interest, which is essentially the cost of borrowing money. When you make monthly payments on a loan, a portion goes towards the principal amount you borrowed, while the rest goes towards the interest.In an EMI payment plan, your monthly payment is a fixed amount that includes both the principal and the interest.
But have you ever noticed that during the initial years of the loan repayment, the interest component is higher than the principal component in most of the cases, although not necessarily? The reason behind this is how the EMI is calculated and the tenure of the Loan
Banks or lenders use a formula that takes into account the loan amount, interest rate, and loan tenure to determine your monthly EMI payment. However, during the initial years, a higher percentage of the payment goes towards the interest than the principal.
Let’s understand this with the help of an example. Suppose you take a home loan of Rs. 50 lakhs at an interest rate of 8.5% for a tenure of 20 years. Using the EMI formula, your monthly EMI payment would be Rs. 43,391. However, in the first year of the loan repayment, out of the total EMI payment of Rs. 43,391, the interest component would be Rs. 3,99,161, and the principal component would be Rs. 55,089. This means that the interest component is almost 90% of the EMI payment, while the principal component is only 10%.
The reason for this is that in the initial years, the outstanding balance of the loan is higher, so the interest charged on it is higher and the tenure is very long (20 years). Additionally, lenders use a reducing balance method to calculate interest. This means that interest is calculated on the outstanding balance after deducting the principal component of the EMI payment. Since the principal component is lower in the initial years, the interest component is higher. However, as you continue to make payments, the outstanding balance decreases, and the interest component gradually decreases. Eventually, towards the end of the loan term, the principal component will be higher than the interest component. Understanding why the interest component is higher in the initial years can help you plan your finances better. If you can afford to make higher payments towards the principal in the initial years, you can reduce the overall interest you pay and pay off the loan faster.
If you keep the years of Loan lesser then also the interest portion can be reduced. for example, lets see how the EMI turns out in 7 years with the same example.
In conclusion, EMI payments are a convenient way to repay a loan, but the initial years’ interest component is usually higher than the principal component due to certain discussed factors like tenure and Balance Loan amount and it gradually evens out towards the end of the loan term. By understanding how the EMI works, you can make informed financial decisions and pay off your loan faster.
Use this calculator for your EMI Planning: Home Loan EMI Calculator