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

(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.

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.

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],

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)

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

Loan Amount outstanding at the beginning of first month = Rs.25, 00,000/-

= (11% of Rs.25, 00,000)

=

(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 , 888/- will go towards principal.

Balance amount

= (EMI)

= (Rs.25, 805/-)

The principal portion in EMIis always equal to (

So the

EMI = Rs.25, 805/-

, 917/-

Principle = Rs.2, 888/-

= (Loan amount outstanding at the beginning of the first month)

= Rs.25, 00,00/-

= Rs.25, 00,000/- , 888/-

= Rs.24, 97,112/-

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

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/-

So

= (11% of Rs.24,97,112/-)

=

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)

= Rs.25,805 - Rs.22,890

= Rs.2,915/-

So the

The loan amount outstanding

= (Principal balance at the beginning of 2nd month) minus (principal portion of 2nd EMI)

= Rs.24,97,112/-

= Rs.24,97,112/-

= Rs.24,94,197/-

The loan amount at the beginning of the third month

= The loan amount outstanding

= 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/-)

= Rs.22, 863/-.

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

Hence principal portion of 3rd month's EMI

= Rs.25, 805/- , 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?

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

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, lFor 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

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

**Interest for the 1st month**= (11% of Rs.25

**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

*Rs.22*, 917/-is the interest__(Refer calculation of interest for 1st month above)____.__The balance amount of Rs.2Balance amount

= (EMI

**minus**(interest for the month)= (Rs.25

**minus**(__Rs.22__, 917/-)

*=**Rs.2*, 888/-The principal portion in EMI

__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

__Interest = Rs.22__

Principle = Rs.2

__(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

**minus**(the principal portion of the first EMI)= Rs.25

**minus**Rs.2= Rs.24

(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/-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

So interest for the 3rd month

= (11% of Rs.24

**divided**by 12= Rs.22

EMI for each month is Rs.25

Hence principal portion of 3rd month's EMI

= Rs.25

**minus**Rs.22= Rs.2

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?

Nice illustration. this blog made my ideas about home loan very clear. It will definitely help me to compare home loans of different banks.

ReplyDeleteThank you

Delete