3 min
26-November-2024
Principal Vs interest breakup: An overview
When borrowing a loan, understanding the breakup of principal and interest in your equated monthly instalment (EMI) is crucial. The EMI consists of two components—principal repayment and interest on the outstanding amount. These components are not fixed but vary over the loan tenure. At the start, the interest portion is higher, gradually reducing as more of the principal is repaid. This distribution impacts your repayment strategy and overall cost. Knowing how lenders calculate these amounts can help you plan better, minimise interest payments, and pay off the principal faster.This article explores the intricacies of EMI structure, focusing on how principal and interest vary, why interest is higher initially, and how tenure impacts the breakup. Additionally, discover repayment schedule details and learn about foreclosure charges.
What is an emi and how does it work?
An equated monthly instalment (EMI) is a fixed payment borrowers make to lenders to repay a loan within a specified tenure. It includes both the principal amount and the interest charged on the loan. EMIs are designed to ensure repayment is manageable, with consistent monthly outflows.Lenders calculate EMIs using a standard formula:
EMI = [P × r × (1 + r)^n] ÷ [(1 + r)^n − 1]
Where P is the loan amount, r is the monthly interest rate, and n is the loan tenure in months.
Each EMI comprises two parts:
- Principal: The portion of the loan amount repaid each month.
- Interest: The cost charged by the lender for providing the loan.
Understanding EMIs helps borrowers plan their finances effectively. For more insights, check out the repayment schedule.
The structure of an EMI: Principal Vs. Interest
The EMI structure evolves throughout the loan tenure, with the ratio of principal and interest components changing over time. Below is a tabular representation of this breakup:| Loan Tenure (Months) | EMI Amount (₹) | Principal Component (₹) | Interest Component (₹) | Outstanding Loan Balance (₹) |
| 1 | 10,000 | 2,000 | 8,000 | 9,80,000 |
| 6 | 10,000 | 3,000 | 7,000 | 9,50,000 |
| 12 | 10,000 | 5,000 | 5,000 | 9,00,000 |
| 24 | 10,000 | 7,000 | 3,000 | 8,00,000 |
| 36 | 10,000 | 8,000 | 2,000 | 7,00,000 |
This table demonstrates how the interest reduces while the principal component increases progressively. Borrowers benefit by understanding these dynamics, ensuring they manage their financial outflows better.
Why is the interest component higher at the start of the loan?
At the start of the loan tenure, the interest component dominates the EMI because interest is calculated on the outstanding loan balance. Since the principal balance is at its peak initially, the interest amount is proportionately higher.As borrowers pay EMIs, the outstanding loan balance gradually decreases. This reduction leads to lower interest calculations over time. Consequently, the principal repayment portion increases. This process is known as loan amortisation, where the interest payment reduces as the principal balance shrinks.
Understanding this concept can help borrowers plan pre-payments strategically. Learn more about the cost of early repayments by exploring foreclosure charges.
How loan tenure affects principal and interest in EMI
- Shorter tenure:
- Higher EMIs but a faster reduction in the principal amount.
- Significantly lower total interest paid over the loan tenure.
- Longer tenure:
- Lower EMIs, making repayments affordable for borrowers.
- Higher total interest paid due to the extended repayment period.
- Mid-tenure adjustments:
- Borrowers can choose to refinance or pre-pay to adjust the tenure and reduce costs.
- Impact on amortisation:
- Short tenures accelerate the shift from interest-heavy to principal-heavy EMI components.
How lenders calculate principal and interest in your EMI?
- Amortisation schedule:Lenders create a repayment schedule dividing EMIs into principal and interest components.
- Interest rate application:The annual interest rate is converted into a monthly rate and applied to the outstanding principal.
- Declining balance method:Interest is calculated on the remaining loan balance, ensuring a dynamic principal-to-interest ratio.
- Tenure consideration:Longer tenures result in higher interest payments due to the prolonged repayment period.
- Prepayments and adjustments:Borrowers making pre-payments can reduce their interest burden and adjust the amortisation schedule.
Why do I pay more interest in the early stages of the loan?
- Higher outstanding balance:Interest is calculated on the total loan amount initially, leading to higher payments.
- Amortisation principle:The EMI structure prioritises interest payments early, gradually shifting focus to the principal.
- Loan tenure factor:Long-term loans amplify this effect, with more interest-heavy EMIs in the initial years.
- Compounding interest effect:Interest accrues more significantly on larger balances, influencing the early EMI structure.
- Lender’s strategy:This approach ensures lenders recover their interest earnings upfront, safeguarding their profits.
Ways to minimise interest payments and pay off principal faster
- Opt for shorter loan tenure:Higher EMIs result in reduced interest costs.
- Make prepayments:Use bonuses or savings to reduce the outstanding balance.
- Increase EMI amounts:Voluntarily pay higher EMIs to accelerate principal repayment.
- Refinance at lower rates:Transfer your loan to another lender offering better interest rates.
- Avoid long tenures:Minimise total interest payments by selecting manageable but shorter tenures.
- Check foreclosure terms:Understand potentialforeclosure charges before settling the loan early.
