The ABC of EMI break-up... and why it is important

Did you say, what's that?

Amortisation is the key that can unlock the secrets of your loan by lifting the numerous curtains that banks put on it when offering you credit.

Here is taking the veil off amortisation and why it has a strong bearing on your pocket.

What is amortisation?

Simply put, it's the break-up of your equated monthly instalments, EMIs, into principal amount and interest you pay every month.

After each payment, the amount you owe the bank every month keeps falling. The interests you are charged with, depends on how much balance you have outstanding every month.

While your EMI amount doesn't change every month, the dynamics of the principal and the interest components do change over the loan tenure.

Here's an example:

Click NEXT to read the example.

The author is co-founder and director, Perfios software Solutions Pvt. Ltd. (www.perfios.com). Perfios offers an online Personal Finance Software Solution that provides a 360 degree view of one's Personal Finance with very little manual effort.

If you have taken a loan of Rs 1,00,000 at a monthly reducing balance rate of say, 15 per cent for 36 months and your monthly EMI is Rs 3,467, then in the first month you will pay Rs 2,217 as principal amount and Rs 1,250 as interest.

In the second month, the principal component will be Rs 2,244 and the interest component Rs 1,223.

In the 35th month, you will be paying Rs 3,382 as the principal and Rs 85 as the interest.

Moral of the story: Your principal payment keeps going up through the loan period and the interest component keeps falling. Which means in the initial months, you have paid up most of the interest on your loan.

When you take a loan, banks are supposed to give you the amortisation chart. Most people, however, don't really bother looking at this chart.

If you're planning to follow the payment schedule to loan maturity, you can be forgiven for not reading the fine print.

But there are some good reasons why familiarising yourself with your amortisation chart is a good idea. Here they are:

1. Clarity on interest rates

How much interest you are paying on a particular loan depends entirely on how much principal you are paying back.

Most of us calculate interest rate on the amount we initially took for the loan. However, this is not right because in each EMI, you pay up some of the principal.

Knowing how much principal you cough up every year tells you what exactly is the cost of the loan you have taken.

2. Clarity on outstanding

Living a financially organised life is always a good idea. This is where the amortisation chart can help you.

It keeps you in the loop about the exact amount you owe your bank at any point in time. Not only is this important for making informed decisions but also for your creditworthiness.

As your debts decline, your creditworthiness goes up. And should you need another loan, you will be eligible for more as each EMI payment goes from your bank account.

3. Clarity on prepayment cost

Traditional wisdom says you must prepay your loans if you can to become debt-free as soon as possible. But wait.

Don't jump to prepay the loan before checking out your amortisation chart.

Loans like personal loans attract a pre-closure charge of between 2 per cent to 4 per cent. If you're nearing maturity of the loan, chances are you have already paid off a huge chunk of the interest you had to pay.

In fact, it might turn out to be costlier for you to prepay the loan than to take it to maturity. So build in the pre-closure charges and then see if it saves you money to prepay the loan or just makes you shell out more.

4. Clarity on tax breaks

If you have taken a home loan, you can actually use it to lower your tax liability. Under the Income Tax Act, you can claim tax break not only on the interest you pay on a home loan but also the principal amount.

How much you can claim in a particular fiscal year depends on how much you have paid your lender. This is where an amortisation chart comes in.

Not only can it help you plan your taxes for this year but also the ones coming up. An informed taxpayer is the richer taxpayer.

Next time the loan amortisation documents arrive after you have signed on the dotted line, don't just throw them into the trashcan. Take out your reading glasses and join the list of the money-savvy.