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Saturday, 17 June 2017

Break up of EMI into Interest and Principle

Loan borrowers are often confused why a major portion of EMI goes to interest and not the principal in the initial period of the loan

1. Is the Bank trying to make me pay more interest?
2. Is the Bank cheating me?
3. Why is such a big amount allocated to interest and not the principle?

These are the most common thoughts that come to a borrower who is a layman. His thoughts are justified as he doesn't know how the EMI gets divided between interest and principal

There can be 2 reasons for this-
(a) He has never asked the logic
(b) He has asked the rationale behind the bifurcation, but the banker has failed to explain the same to him

The good news is that there is no rocket science involved behind the division of EMI into principal and interest. It’s just a simple math.


Let us first understand what is EMI?

EMI stands for equated monthly installments. It is the amount that the borrower has to pay equally every month throughout the tenure of the loan such that the loan balance at the end of tenure of the loan becomes zero. (Assuming that the borrower wouldn't make any prepayments during the course of the loan)

Why is there a need to calculate EMI?

Suppose you take a loan. Can you repay the loan as per your own whims and fancies?

The Answer is a big NO. Banks do not have a system to handle so many complex transactions where each borrower can repay the loan as per his/her convenience.

So it is important for banks to arrive at a figure which borrower can pay equally every month so that the loan gets repaid within the tenure of the loan.

So how is this EMI amount arrived at?

There is a slightly complex mathematical formula involved in the calculation of EMI amount. 
You don’t need to manually calculate the EMI using the formula as there are lots of calculators available online where you just have to enter the value of the principal, the rate of interest per annum & tenure and you get EMI automatically. The formula is as given below
 
EMI = [P x R x (1+R)^N]/[(1+R)^N-1],

  • P stands for the loan amount or principal,
  • R is the interest rate per month. If the interest rate per annum is 11%, then the rate of interest per month will be 11% divided by 12 = (11/100)/12
  • N is the number of monthly installments.
 
The above mentioned formula gives you the amount which needs to be paid equally every month so that your loan gets over at the end of the tenure of the loan. (Assuming you wouldn't make any prepayments during the course of the loan)
 
For example, l
et's assume that-
Loan amount is Rs.25, 00,000/-, 
Rate of interest is 11% and
Tenure of the loan is 20 years.

So,

P = Rs.25,00,000/-


R = Rate of interest per month
= (Annual Interest) divided by 12
= 11% divided by 12
= (11/100) divided by 12.

N = 240 months (In the formula N is number of months. So 20 years mean 240 months)
 
Applying the above formula, EMI will come to Rs.25, 805/-(Rounded off). 
 
Now that we know the calculation of EMI, let’s understand the bifurcation of EMI between interest and principal
 
The formula of EMI calculates EMI in such a way that-
(a) At least the interest portion of every month gets covered fully in EMI &
(b) Principle amount gets divided over the period of the loan in such a way that the borrower has to pay a fixed amount (EMI) every month
                         
The bifurcation of EMI into principle and interest is called amortization.
 
Now let’s go back to our same example. Let’s understand the bifurcation now
 
The bifurcation happens in the following manner-
 
1st Month
Loan Amount outstanding at the beginning of first month = Rs.25,00,000/-

Interest for the 1st month
= (11% of Rs.25,00,000) divided by 12
Rs.22,917/-.


(11% is the interest per annum. So to get interest for one month, we need to divide the annual interest by 12)
 
The EMI arrived as per mathematical formula of EMI is Rs.25,805/- out of which Rs.22,917/- is the interest (Refer calculation of interest for 1st month above). The balance amount of Rs.2,888/- will go towards principal.

Balance amount


(EMI) minus (interest for the month)

= (Rs.25,805/-minus (Rs.22,917/-)

Rs.2,888/-

The principal portion in EMI is always equal to (EMI) minus (the interest for that particular month)
 
So the first month’s break up of EMI into interest and principal is as follows-


EMI = Rs.25,805/-

Interest = Rs.22,917/- 


Principle = Rs.2,888/-(Balance amount remaining after deducting interest of the first month from EMI of the first month)


The loan amount outstanding at the end of first month
= (Loan amount outstanding at the beginning of the first month) minus (principal repaid in first EMI)
= Rs.25,00,00/- minus (the principal portion of the first EMI)
= Rs.25,00,000/- minus Rs.2,888/-
= Rs.24,97,112/-





(Click and then enlarge the above image for better view)


2nd Month
The loan amount outstanding at the beginning of second month

= The loan amount outstanding at the end of first month
= Rs.24,97,112/-
 
In the second month the interest will be calculated on Rs.24,97,112/- and not Rs.25,00,000/-. This is because the loan balance at the beginning of the second month is Rs.24, 97,112/-. 
 
So interest for second month
= (11% of Rs.24,97,112/-) divided by 12
Rs.22,890/-.

The EMI of Rs,25,805/- will be the same for the entire tenure of the loan.

So balance amount of Rs.2,915/- will go towards the principal. 


The Balance Amount of Rs.2,915/- is arrived as follows -
(
EMI)  minus (the interest for the second month)
= Rs.25,805 - Rs.22,890
= Rs.2,915/-


So the 2nd month’s EMI break up will be as follows-
EMI = Rs.25,805/-
Interest for 2nd Month = Rs.22,890/-
Principle (Balance Amount) = Rs.2,915/-


The loan amount outstanding at the end of 2nd month 
= (Principal balance at the beginning of 2nd month) minus (principal portion of 2nd EMI)
= Rs.24,97,112/- minus (the principal portion of the second EMI)
=
 Rs.24,97,112/- minus Rs.2,915/-
= Rs.24,94,197/-

3rd Month 
The loan amount at the beginning of the third month
= The loan amount outstanding at the end of 2nd month
= Rs.24,94,197/- (as calculated above)

In the third month, the interest will be calculated on Rs.24,65,646/- (Outstanding Loan amount at the beginning of the 3rd month).

So interest for the 3rd month
= (11% of Rs.24,65,646/-) divided by 12
= Rs.22,863/-.

EMI for each month is Rs.25,805/-.

Hence principal portion of 3rd month's EMI
= Rs.25,805/- minus Rs.22,863/-
= Rs.2,941
 
If you continue bifurcating EMI for 20 years the way it is given above, you will find that each month, the interest portion of EMI keeps on decreasing and the principal portion keeps on increasing. This is because Loan amount outstanding is highest in the first month and then it keeps on reducing. Since the outstanding loan amount keeps on reducing after payment of each EMI, the interest portion of EMI also keeps decreasing. EMI will, however, remain the same for entire tenure and the amount of principal at the end of 20th year will become zero.  


This is how the EMI is bifurcated between Interest and Principal. Having gone through this, now you don't need anyone to explain you why in the initial period, the major portion of EMI  goes towards interest, do you? 

Friday, 16 June 2017

Factors affecting your Home Loan eligibility

“My income is Rs. Xxx/-. What is my home loan eligibility?"

This is one question that we frequently hear from the customers when we first meet them. Deciding the home loan eligibility is not so easy and neither it is so simple. This is because there are a lot of other factors which are taken into account while arriving at home loan eligibility. The reason behind this is that no two individuals with same income have exactly the same repayment capacity.

For example, suppose Mr. A and Mr. B both have a monthly income of Rs.25,000/- each. But Mr. A has an ongoing personal loan whose EMI is Rs.2,000/-. So would both of them have same home loan eligibility? The answer is obviously NO.

So then let's see what all are the factors that impact home loan eligibility of a borrower-


 1. Income - Monthly income is definitely the most important factor that impacts home loan eligibility. Other things remaining equal, higher the income higher will be his eligibility

2. Current Obligations - Current obligations of a borrower also have an impact on his home loan eligibility. We have already discussed this in the example of Mr. A and Mr. B mentioned above. Other things remaining equal, higher the monthly obligations lower will be the eligibility.

3. Age - Age is also an important factor taken into consideration while arriving at home loan eligibility of a borrower. Suppose, Mr. X has a monthly income of Rs.50,000/- which is same as that of Mr. Y. However, Mr. X is just 25 years old, whereas Mr. Y is 55 years old. In this case, Mr. X will be eligible for a higher loan amount as compared to Mr. Y. This is due to the fact that Mr. X will retire after 35 years, whereas Mr. Y will retire after 5 years (Assuming the retirement age to be 60 years for both). So banks would be willing to offer a higher loan amount to Mr. X as compared to Mr. Y as Mr. Y won't be having his current income after 5 years whereas Mr. X will continue to earn for 35 more years.

4. The Income of the co-applicant - Housing Finance companies these days insist on having a co-applicant to the loan. However, they do consider the income of co-applicant is certain cases while arriving at loan eligibility. For instance, the income of the wife can be clubbed with the income of her husband thereby increasing his eligibility. Hence, if co-applicant is an earning member of the family, then it can help increase the loan eligibility of the main applicant

5. Valuation of the property - Valuation of the property to be purchased is also taken into consideration while deciding home loan eligibility. Banks give anywhere between 75% to 90% of the cost of the property depending on the loan amount. Loan amount cannot exceed these limits under any circumstances, even if the borrower is eligible for a higher amount based on his income.

Wednesday, 14 June 2017

Classification of Commercial Organizations on basis of Ownership

On the basis of ownership, the commercial organizations can be classified into 3 major categories -Private Sector Enterprises, Public Sector Enterprises and Joint Sector Enterprises
  
Private Sector Enterprises- These are the businesses which are owned, controlled and financed by a private businessman. There is no government participation in such form of business organizations.

Following are some of the features of Private Sector Enterprises-


1. Private Ownership and Control- A private sector undertaking is fully owned and managed by private entrepreneurs or businessmen. It may have just one owner or more than one owner. When there is only one owner, he is called as a sole proprietor and this form of business is called as Sole Proprietorship. If there is more than one owner then the organization may be  a Joint Hindu Family Business or a Partnership Business or a Joint Sock company or a Co-operative Society

2. Profit motive - The main purpose of   Private sector enterprises is to earn Profits.

3. No Government Participation - There is no government participation in such a form of business organization

4. Independent Management -  Private sector enterprises are  managed independently by the owners. 

5. Private Finance - The capital of private sector organization is arranged by the owners themselves.

Public Sector Enterprises - These are the businesses which are owned and controlled by the central or state government. 

Following are some of the features of public sector enterprises

1. State Ownership -  The public sector  enterprises are fully owned by the government. For example,  the Reserve Bank  of India is owned by the central government

2. Control of government -  The management of such organizations is in the hands of government

3. Service Motive - The major objective of such organizations is to provide services to the citizens of the country.

4. State Finance - The funds required to run these companies is provided by the government.  These funds are provided either through budget or by way of loans.

5. Public Accountability -  These undertakings are accountable to the public at large as tax payers' money is utilized by the government to invest in such companies. Hence the audit of such companies is carried out each year by the Comptroller and Auditor General of India (CAG)

Joint sector enterprises - Under this form of business organization the ownership  and management is shared jointly by government,  private entrepreneurs and public at large. For example, BHEL (Bharat Heavy Electricals Ltd)

The main features of joint sector enterprises are as follows-

1. Mixed Ownership - The joint sector companies or enterprises are owned jointly by government, private businessmen and people at large

2. Combined Management - The management of such companies is done jointly by representatives of the government, the private businessmen and the public

3. Joint Finance - The capital of such businesses is jointly financed by the government, the private entrepreneurs and people at large

Tuesday, 6 June 2017

Life Insurance and different types of Life Insurance policies

What is Life Insurance?

Under life insurance, the subject matter of insurance in human life. The human life is the insured against various risks like accident, death, etc.

Life Insurance is basically for legal heirs of the person insured, i.e. Legal heirs of the person on whom the life insurance is taken. So, in the event of death of the person insured, the insurance amount goes to the legal heir

Various types of life insurance policies-

1. Whole life Policy - Under this policy, the whole life of a person is insured. The person who is insured cannot receive any amount under this policy. Insurance amount is paid to the nominee or the legal heirs of the person insured on his death. The rate of premium is very low in case of whole life policy

2. Term Plan - A term plan is similar to a whole life policy. The only difference is that under term plan, the person is insured for a specific period only like 10 years, 15 years, etc. The premium of a Term plan is lowest among all types of life insurance policies. Suppose if a person has taken a term plan for say 10 years. The nominee will get the insurance amount if the person insured dies within the term of the plan (which is 10 years in our example). If the person survives the tenure of the policy he gets nothing in return

3. Endowment Policy - Again, this policy is not for whole life. It’s for a specific period only. Under this policy, the nominee or legal heir gets the sum assured (the insurance amount) plus a bonus in the event of the death of the person insured. The Bonus is some extra amount which is paid by the insurance company over and above the sum assured. However, if the death of the insured doesn’t happen within the tenure of the policy, then he himself gets the sum assured plus bonus on completion of the term of life insurance policy. The bonus amount depends on income earned by the insurance company by investing a certain portion of the premium in various assets like government securities/bonds etc.

4. Money back policy - Under this policy a certain percentage of insurance amount is paid regularly (to the person insured) during the lifetime of the policy. It can be after every 3 years or 4 years or 5 years etc. In the event of the death of the person insured, the nominee gets full sum assured. The policy comes to an end with the death of the person insured.

5. Joint life policy - Under this policy, two or more individuals are jointly insured, For example, the individuals can be husband and wife or it could be all the partners of the partnership firm. The sum assured/policy amount is paid at the end of the term of the policy or on the death of any one person whichever is earlier.

6. Annuity policy - This policy is basically for retirement planning. Under this policy, the person insured pays the premium in a lump sum or in installments over a certain period of time. The person insured will get a specific amount periodically from a specified date onward for the lifetime or for a fixed number of years depending on the terms and conditions of the policy

7. Unit linked insurance plans - This policy is similar to endowment policy. Under endowment policy, a certain percentage of premium amount is invested in safe investments like Government securities, bonds, etc. So there is not much risk involved in such types of Investments. Hence the surety of getting a decent bonus is much more. Whereas in unit linked plans, the investment made by the insurance company is in slightly riskier assets like shares, etc. So the surety of getting a good bonus is not there and you may also end up getting a negligible or maybe even zero bonus

Monday, 5 June 2017

Forms of Business Organizations - Sole Proprietorship Concern and Partnership Firm


What is a Sole Trading Concern/Sole Proprietorship Firm?

Sole Trading Concern is an informal type of Business Organization which is owned, managed and controlled by an individual

Features of Sole Trading Concern are –
-Minimum Government Regulations (Doesn't require any registration)
-Liability of the owner is unlimited
-Freedom in the selection of business. Hardly any restriction on type of a business that a sole trader can do
-Highest Secrecy- Sole trader doesn't have to share his financial or any other business secrets to anyone
-Single Ownership and Management
-Direct Contacts with the customers and employees
-Suitable for small businesses
-No sharing of profits and risks

Merits of Sole Trading Concern are:
-Easy Formation (Doesn't require registration)
-The benefit of Secrecy. No sharing of business secrets with any outsider and no legal compulsion to publish accounts
-Direct Motivation (More efforts means More profits). No sharing of profits with anyone
-Quick Decisions can be made as sole trader doesn't have to consult anyone before taking any decision
-Flexibility In Operations. Sole trader can keep on changing his plans quickly as per business environment
-Limited Government Control. No specific law to govern operation of sole trading concern

Limitations of Sole Trading Concern are:
-Limited Managerial Ability (Only One Owner can't manage a very big business)
-Limited Amount of Capital. (Owner is the only one who invests in the business and so cannot invest beyond a certain point)
-Unlimited Liability of the owner
-Not Suitable for large scale operations which require a lot of capital and more managerial abilities
-No Perpetual Existence (Sole Proprietorship may come to an end in case of death or insolvency of the owner)

What is a Partnership Firm?

Partnership firm is a form of business organization which has more than one owners. It is owned and managed by more than one person. All the owners share profits and losses and their liability is unlimited. The owners are called as partners

The features of Partnership are:
1. The partnership comes into existence only if there is an Agreement between the owners (Partners). Agreement can be oral or in written form
2. Registration of the Firm is not mandatory except in the state of Maharashtra
3. Lawful Business - Partnership firm can do any business which is lawful in nature
4. Membership- Minimum 2 partners are required. Maximum can be 20 except in case of a banking business where max no can be 10 only)
5. Sharing of Profits and Losses- There has to be sharing of profits and losses though it may not necessarily be equal
6. Unlimited Liability- Liability of all the partners is unlimited except in case of a minor partner
7. Management- The business may be managed by on or few or all the partners based on their mutual understanding
8. Dissolution- Death, Insolvency or Insanity of any partner will lead to dissolution of the firm
9. Relationship Between Partners is that of a principal as well as agent

Types of the Partners –
-Active Partner: One who actively participates in day to day management of the business
-Sleeping: One who doesn't participate in day to day running of the business
-Nominal Partner: One who just lends his name to the firm. He neither contributes the capital nor takes part in day to day management of the business
-Minor: One who is less than 18 years old
-Partner in Profits only: One who shares only profits but not the losses
-Partner By Estoppel: One who is not an actual partner but presents himself to the be the partner of the firm. He is liable to the person who suffers any loss by doing a business with the firm based on assumption that he is actual partner of the firm

Merits of Partnership are:
- More Manpower as compared to Sole Proprietorship Concern
-More Financial Resources  as compared to Sole Proprietorship Concern
-Ease of Formation as registration is not compulsory except in the state of Maharashtra
-Easy Dissolution as there are not many legal formalities involved in closing the business
-Division of Risk as there are more than one owners
-Better Decision Making as decisions are taken jointly

Limitations of Partnership are:
- Unlimited Liabilities of the owners
- No Separate Legal Status (The owners and the business are one and te same in eyes of law)
- Limited Resources as compared to other forms of business organizations like a Private Limited Company or a Public Limited Company
- Disputes among the Partners may lead to loss of the goodwill or closure of the business
-The risk of Implied Authority: Bad Decision taken by one partner may result in loss to all the partners






For more detailed explanation visit-
Merits and Demerits of a Partnership Firm