Understanding the Impact of Interest Rate Changes on EMI

Earlier, my LIC HFL interest rate was revised from 14.55% to 8.95%, effectively reducing my loan tenure by one year while keeping the EMI fixed. This adjustment has raised some questions, particularly about why the EMI did not decrease. Here, we’ll explore the intricacies of EMI calculations and dispel a common misconception.

Introduction to EMI Calculation

The Equated Monthly Installment (EMI) is a crucial aspect of loan repayment. Banks and financial institutions provide this estimation to borrowers as a helpful tool for understanding their monthly financial obligations and loan repayment timelines. An EMI helps borrowers plan their finances effectively.

Before delving into the reasoning behind the EMI adjustment, it’s important to understand the basic formula and process:

The loan is repaid with a combination of the principal amount and interest. The EMI calculation primarily depends on the principal amount, the interest rate, and the tenure. The borrower pays the EMI monthly for a fixed period.

Example of EMI Calculation

Let's consider a hypothetical example for clarity:

Example 1:

Principal amount: Rs. 300,000 Annual interest rate: 9% Loan tenure: 30 months

Using the standard EMI calculation formula:

Total EMI: (Principal x Rate x (1 Rate) ^ Tenure) / [(1 Rate) ^ Tenure - 1]

In this case, the monthly EMI would be approximately Rs. 2,300 towards interest and Rs. 10,000 towards the principal amount.

Change in Interest Rate Impact on EMI

Now, considering the revised interest rate of 9%, the total EMI calculation changes slightly. The borrower initially paid Rs. 2,300 towards interest, but due to the reduction in the interest rate, only Rs. 2,292 is paid this month. This decreased amount is due to the reduced rate, but the principal payment remains the same.

Reasons for Fixed EMI Despite Reduced Tenure

The reason why the EMI remains fixed despite a decrease in tenure is due to the underlying financial assumptions and the compound interest effect. When the interest rate reduces, the borrower pays less interest, which frees up the principal amount to be repaid in the remaining tenure. However, the total EMI is adjusted based on the original tenure and rate to keep the monthly payment consistent.

Here's a simplified illustration:

Example 2:

Loan amount: Rs. 300,000 Loan term: 10 years (120 months) @ Interest rate: 9% Monthly EMI: Rs. 3,800

Loan Summary: Loan Amount: Rs. 300,000 Interest Payable: Rs. 156,033 Total Payable: Rs. 456,033

In reality, only Rs. 300,000 is recorded in the loan account, not the full Rs. 456,033. The balance outstanding would be Rs. 298,450 after the first monthly EMI.

Additional Considerations

EMI is a calculation of several assumptions, including the full loan disbursement and planned installment releases. If the stages of loan disbursement differ from the assumed timelines, it can affect the residual amount left. For example, if EMI payments are made on different dates throughout the repayment period, it can lead to residual amounts.

Conclusion

Understanding the impact of interest rate changes on EMI is vital for proper financial planning. While the EMI may remain fixed despite a reduction in tenure, it's important to know the breakdown of payments and the underlying mathematical principles. This knowledge helps in making informed decisions regarding loan repayment and financial planning.