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EMI stands for Equated Monthly Installment. This has become the mantra for many retailers and also banks. The financial institutions are ready to give loan to buy anything under the sun and collect the amount back in EMI.
Many people think that it is a good way to possess things or gadgets. It is not a good way. It is a very bad way and if you keep doing that then I am sure you will be in deep trouble. I had the privilege of checking my friend’s repayment schedule of his two wheeler loan. To my surprise, the principal amount was not decreasing at the same rate as that of interest.
The catch with the bank loans is that, even if you plan to pre close the loan, you would be in the losing side and not in the winning side. Let me explain it to you. Consider that the loan that you have taken is 50,000 at the rate of 15% per annum for 2 years tenure.
EMI is calculated using the following formula:
EMI = {(p*r) (1+r)^n}/ {(1+r)^n – 1}
p = principal (amount of loan), r = rate of interest per installment period, i.e., if interest is 12% p.a. r = 1, n = no. of installments in the tenure, ^ denotes whole to the power
EMI: 2424 if monthly reducing and 2563 if yearly reducing balance.
You can notice that you will be paying around 10000 more depending on the reducing balance option that you have got. When you apply for a loan, the bank charges around 1 – 2 % as processing charges and also the principal amount does not reduce on equal basis i.e. principal amount – 50k /24 = 2083.3, Simple interest: 15k/24 =625. If we do a rough calculation then you will think that we need to pay 2083 + 625 every month and if you want to pre close the loan then we can pay it off by paying a penalty of about 2 to 5 percent depending on the bank.
This is not true. The banks don’t calculate the way I have calculated. It is always the interest amount that is more in the initial few months than the principal amount. Even the bank officials know that there are smart people who want to do such a thing and they have come up with a plan to ensure that they make profit even if a customer pre closes his loan.
I was not aware of this kind of calculation, it is surprising but that is how it will work otherwise bank won’t make profit. However you calculate, buying gadgets on EMI is not going to be any beneficial to you. Think over before buying anything on EMI.
Engineer's Finance 