When taking out a loan, understanding the different types of Equated Monthly Installment (EMI) options is crucial for managing your finances effectively. The way interest is calculated and the type of EMI structure you choose can significantly impact the total amount you repay over the loan period. This article delves into the four primary EMI methods: Floating, Fixed, Flat, and Reducing Balance, helping you make an informed decision
Understanding the Four EMI Methods
Each EMI method—Floating, Fixed, Flat, and Reducing Balance—offers a unique approach to interest calculation and repayment structure. While Fixed EMIs provide stability with a constant interest rate, Floating EMIs fluctuate based on market conditions. The Flat and Reducing Balance methods differ in how the interest is calculated, with the latter offering potential savings by recalculating interest on the outstanding principal. Understanding these differences can help borrowers select the most suitable option for their financial needs.
Floating Rate EMI
Loans are financial products and their cost largely depends on the market forces and a number of policies of the central bank of the country. To be more specific, factors like the repo rate, cash reserve ratio (CRR) and several other regulations by the government affect the interest rate. Moreover, after the recent notification by the Government of India, the banks are allowed to choose any of the external market factors to decide the interest rates. A borrower can choose between fixed EMI and floating EMI depending upon his/her preference.
Floating rate EMI, as the name suggests, is variable, i.e; is subjected to change with the market scenario. It has a base rate and a floating element and the latter varies directly if there is a change in the former. This means that the interest rate may change according to the market forces and will, in turn, change the EMI. Usually, floating interest rates are less than fixed interest rates and that too with a sufficient margin. This ensures that the lender will still pay less (generally) if he/she has opted for floating rate EMI compared to fixed rate EMI.
For example, if the floating rate is 11% and the fixed rate is 15% then even an increment by 3% will not make the floating rate EMI costlier than the fixed rate EMI.
However, if you have a predetermined budget, floating rate EMI should be avoided. Also, one needs to have an eye over the interest rates, continuously.
Flat Rate EMI
Flat rate EMI or to say flat rate interest is a predetermined rate of interest where the interest is calculated on the full principal loan amount for the entire term without taking into consideration that periodic payments reduce the loan amount.
It is calculated by dividing the total principal loan amount by the number of periods and then adding it to the amount of interest. To be sure, the interest amount itself is calculated on the total loan and is then divided by the number of periods in which the EMIs are to be paid.
Take the following example:
A loan amount of 12,000 at an interest rate of 5% per year for one year would amount to (12000/12) + (5% of the loan/12), making the EMI be 1,050, to be paid per month for 12 months.
Flat rate EMI is for those people, who have a rigid budget, which they don’t want to change during the entire loan reimbursement period. This also means that it obliterates the advantages gained by the borrower by paying EMIs faster or repaying the loan before the stipulated time period. No matter how fast the borrower repays the loan, he/she will have to pay the same predetermined interest amount, as decided in the loan bond. However, the key advantage of Flat rate EMI is its simplicity, with its basic lending and borrowing formalities. The calculations itself are not subjected to any kind of change, which to a great extent simplifies the EMI paying process.
EMI Reducing Balance Method
The EMI reducing balance method or simply the Reducing Balance Method is the method wherein the interest to be paid depends on the remaining loan amount and hence changes (diminishes) the interest amount after every paid instalment. This type of interest is generally used in housing or mortgage property loans and is highly preferable over Fixed Interest Rate. The reason behind this is nothing but the decreasing EMI amount over consecutive payments.
Let us understand this in simpler words. At first, the interest is calculated on the entire loan amount, which is to be paid in the first EMI. After paying the first instalment, the remaining loan amount decreases and the next interest to be paid is calculated on the remaining loan amount. This reduces the interest and subsequently the EMI itself since the decrease in the loan amount. The process continues and with every payment of the EMI, the interest continues to decrease further.
To make this more clear, let us take an example. Suppose a customer takes a housing loan of 20 lakh with a 10% interest rate (per annum). The first EMI to be paid will be 19,301, in which the first month’s component in the monthly instalment is 16,666 and the rest 2,624 as repayment of the principal amount. Hence at the end of the first month, the remaining balance becomes 19,97,366 (20,00,000-2624). In the second month, the interest will be charged on 19,97,366 and not the original sum (20,00,000). In this way, the interest goes on decreasing, resulting in the subsequent decrement of EMIs.
With all this knowledge, it is necessary to choose the best option that maximises your savings while reimbursing the loan. Floating rate EMI serves the borrowers who expect the market forces to play in their tune, while the Flat rate EMI is for those who have a fixed budget and don’t like dealing with external factors. On the other hand, the reducing balance method for EMI calculation is safe as well as economical. This continues to go on decreasing and can also be calculated prior to the payment of instalments.
However, the interest rates in the last two are not influenced by any external factor or market forces, whereas the Floating interest rate, although being generally less but changes accordingly with other indicators.
Read Also: Equated Monthly Instalments (EMI)
