Principal
The principal is the original amount of money you borrow from a lender. In an EMI calculation, the principal is the starting balance on which interest is charged.
- Loan payments reduce the principal over time.
- The principal may also be called the loan amount or the face value of the loan.
Interest Rate
The interest rate is the percentage of the principal that a lender charges for borrowing money. It is usually expressed as an annual rate, but monthly rates are used in EMI calculations.
- The nominal interest rate is the rate used in the EMI formula to calculate periodic interest.
- The APR (annual percentage rate) includes fees and other costs, so it can be higher than the nominal rate.
Tenure (Loan Tenure)
Tenure is the total length of time you have to repay the loan. It is often expressed in years or months, and it directly affects the EMI amount and the total interest paid.
- Longer tenure reduces the EMI but increases total interest.
- Shorter tenure increases the EMI but reduces total interest.
EMI (Equated Monthly Installment)
EMI stands for Equated Monthly Installment. It is the fixed amount you pay each month to repay a loan, including both principal and interest, over the agreed tenure.
The standard EMI formula is: EMI = P × r × (1 + r)^n / ((1 + r)^n - 1), where P is the principal, r is the monthly interest rate (annual rate divided by 12), and n is the number of monthly installments.
- EMI remains the same each month when the interest rate and tenure are fixed.
- The EMI formula assumes monthly compounding and a reducing balance method.
Amortization
Amortization is the process of paying off a loan over time through scheduled payments that cover both interest and principal. Each monthly payment is split between interest and principal, and the principal portion grows over time while the interest portion shrinks.
- An amortization schedule shows each payment's split between principal and interest.
- Early payments are mostly interest; later payments are mostly principal.
Reducing Balance Method
The reducing balance method calculates interest on the outstanding principal balance, which decreases with each payment. This method is common for home loans, personal loans, and car loans.
- Interest is charged only on the remaining balance, not the original loan amount.
- As you pay down the principal, the interest portion of each EMI decreases.
Flat Rate Method
The flat rate method calculates interest on the full original principal for the entire loan tenure, regardless of how much principal you have repaid. This method is less common for modern loans and generally results in a higher effective interest rate compared to the reducing balance method.
- With a flat rate, the interest amount remains constant each month.
- The effective annual cost of a flat-rate loan is higher than the nominal rate suggests.
Frequently asked questions
What does EMI stand for?
EMI stands for Equated Monthly Installment. It is the fixed monthly payment you make to repay a loan, including principal and interest, over the loan tenure.
What is the difference between principal and interest?
The principal is the amount you borrow, while the interest is the cost charged by the lender for borrowing that amount. Your monthly payment goes toward both.
How does loan tenure affect my EMI?
A longer tenure reduces your EMI because the loan is spread over more months, but it increases the total interest paid. A shorter tenure increases the EMI but reduces total interest.
What is amortization in simple terms?
Amortization is the gradual repayment of a loan through scheduled payments that cover both interest and principal. Over time, more of each payment goes to the principal and less to interest.