How loan repayment process works

Written by fe Bureau | Updated: Sep 10 2011, 05:56am hrs CEO Adhil Shetty explains important elements in the loan taking process

To meet some of your goals like buying a car or building a home might require additional financial help in the form of a loan from a bank. In the current scenario of rising interest rates it is vital that you understand important elements in the loan taking process.

What is an EMI

An equated monthly installment (EMI) is the amount that is paid back to the lender on a monthly basis. It is essentially made up of two parts, the principal amount and the interest on the principal amount divided across each month in the loan tenure. The EMI is always paid up to the bank or lender on a fixed date each month until the total amount due is paid up during the tenure.

During the initial years the interest component repaid is higher and during the latter years of repayment the principal component is higher. So, if you think you have paid half of the amount borrowed from the bank in 5 years in a 10 year loan tenure that would not be the case. You would probably have reduced the total interest component due considerably and would have only repaid the interest component for the most part.

Here is a simple example that explains how the repayment of your EMI reduces your loan amount during the repayment period leading up to the end of the loan tenure.

Consider a loan amount of R20 lakh, which is lent at an interest rate of say 10% for 10 years. The monthly EMI is calculated at the annualised rate of 10% and amounts to R 26,430 per month.

In the case of large loan amounts with long tenures, the interest component will be the greater portion of the EMI, which will reduce leading up to the end of the loan tenure, while the reverse is true for the principal component.

Remember to request your bank for an amortisation table, which will indicate at any point in time, what exactly your outstanding loan amount is!

EMI and your income

EMI is generally restricted to 30% or 40% of your monthly income . Salary details, qualifications, employer/business, years of experience, growth prospects, alternate employment prospects and sources of other income, if any, are all aspects that determine the amount of loan you are eligible for.

Generally, the repayment schedule is worked out in a manner that allows only around 40-50% of your monthly take home income to be repaid as EMI. It is thus restricted keeping the following factors in mind:

n 10% of your income is spent on other loans, if you have any or if you avail one in the future.

n 20-25% of your income could be deducted by way of statutory deductions and for investment purposes.

n 20-25% of your income is generally spent to meet your monthly expenses.

n This leaves back around 40-50%, which is taken as your repayment capacity for your loan.

For self-employed applicants, profit is the benchmark that determines loan value. The longer the time frame for repaying the loan the lower the EMI and this also means you can opt for a larger loan amount. The loan amount you are eligible for is also dependent on other factors like the company you are employed with, city of residence and your credit history.

A long term loan is part of your budget every month. If you invest too much into it, there might not be adequate funds to manage a huge list of other expenses that will tend to accumulate with time.

In case of spike in interest rates, banks increase the loan tenure in order to not put the loan taker in a tight spot.

However, if you have adequate funds, you can prepay at regular intervals, allowing scope for closing your loan early.