A lot of home loan-seekers don’t really understand the concept of equated monthly installments (EMIs) and how it works. In this tutorial, we have endeavored to unravel this ‘mystery’.
In the initial years, a major portion of the EMI goes in servicing debt (i.e. the interest) only. Here interest component could be as high as 80% of the EMI value.
Surprised! Lets see how.
If you are taking a home loan, then housing finance company (HFCs) will ask you to repay the loan amount in equal installments every month. This repayment which you make every month to the HFC is termed as the EMI. Each EMI has a principal and an interest component.
The value of the EMI depends upon the loan amount, interest rate charged for the loan and the duration in which the loan is to be repaid. Although EMI is the sum of the principal and interest components, the calculation is tilted more in favor of HFCs as in the initial years. HFCs collect more interest than principal but as the tenure approaches towards the end, the principal component of the loan increases.
Sounds confusing?
Lets take an illustration to understand this:
Loan amount: Rs 1,000,000
Interest: 12.25%, annual reducing
Years: 15
EMI: Rs 12,400
Typical repayment schedule for the loan would be:
| Years |
EAI (Rs) |
Interest (Rs) |
Principal (Rs) |
Principal outstanding (Rs) |
Interest/ EAI |
Principal/ EAI |
| 1 |
148,789 |
122,500 |
26,289 |
973,711 |
82.33% |
17.67% |
| 2 |
148,789 |
119,280 |
29,510 |
944,201 |
80.17% |
19.83% |
| 3 |
148,789 |
115,665 |
33,124 |
911,077 |
77.74% |
22.26% |
| 4 |
148,789 |
111,607 |
37,182 |
873,895 |
75.01% |
24.99% |
| 5 |
148,789 |
107,052 |
41,737 |
832,158 |
71.95% |
28.05% |
| 6 |
148,789 |
101,939 |
46,850 |
785,308 |
68.51% |
31.49% |
| 7 |
148,789 |
96,200 |
52,589 |
732,719 |
64.66% |
35.34% |
| 8 |
148,789 |
89,758 |
59,031 |
673,688 |
60.33% |
39.67% |
| 9 |
148,789 |
82,527 |
66,262 |
607,426 |
55.47% |
44.53% |
| 10 |
148,789 |
74,410 |
74,379 |
533,046 |
50.01% |
49.99% |
| 11 |
148,789 |
65,298 |
83,491 |
449,555 |
43.89% |
56.11% |
| 12 |
148,789 |
55,071 |
93,719 |
355,837 |
37.01% |
62.99% |
| 13 |
148,789 |
43,590 |
105,199 |
250,638 |
29.30% |
70.70% |
| 14 |
148,789 |
30,703 |
118,086 |
132,552 |
20.64% |
79.36% |
| 15 |
148,789 |
16,238 |
132,552 |
0 |
10.91% |
89.09% |
| Total |
2,231,837 |
1,231,837 |
1,000,000 |
|
|
|
EAI: Equated annual installment
We know that the EMI comprises of interest and principal components but if we look at the table, we notice that in the first year of repayment, 82.33% of the EMI is the interest component and only 17.77% is the principal component. This is not all, interest component reduces to 50% or less only from 10th year onward. In fact, in the above example, HFCs are collecting almost 83% of the total interest you would be paying over the term of the loan and only 53% of the total principal to be paid within 10 years.
So, in the initial years, a major portion of the EMI goes in servicing debt and therefore contribution towards interest component is very high. If you decide to prepay in these initial years the prepayment charge would be considerably high. It is to be noted here that prepayment charge is a percentage (0 to 3%) of the principal outstanding and in the initial years your contribution towards principal component is very low (refer the table). For example if you decide to prepay your outstanding loan at the end of 5th year, the prepayment charge is say 2%. This will result in cash outflow of Rs 16,643 and the outstanding loan amount is Rs 832,158. The interest cost of finance would be significantly high. To give you an idea, you have paid Rs 576,103 as interest to the HFC and Rs 16,643 as pre payment charges for using Rs 1,000,000 for 5 years. You can well imagine the interest cost!
So, when you apply for a housing loan, chose the term very carefully and don’t rush in to repay the loan a head of the schedule. You would be losing on account of tax benefit associated with housing loan also.
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