EMI stands for Equated Monthly Installment for the loan you avail of from your bank or other lenders. Each installment of the loan repaid under EMI consists of the principal portion of the loan amount and the interest paid on the loan based on the tenure of the loan, and rate of interest. The principal paid is deducted from the opening principal outstanding balance to arrive at the opening principal for the next month and interest is computed on the new, reduced principal outstanding.

For example, you have availed a loan of Rs.50 lakhs at the interest rate of 9% repayable in 240 months; the EMI for the loan repayment is worked out as under.

The formula for calculation of EMI is E= P x R x (1+R) ^N / [(1+R) ^N)-1] Where E= EMI, P = Principal amount of the loan, R = Rate of interest, N = Number of monthly installments.

Interest @ 9% P.A =0.0075per month

E= P x R x (1+R) ^N / [(1+R) ^N)-1]= (5000000 x 0.0075) x (1.0075)^240/{ (1.0075^240)-1}

(5000000 x 0.0075)= 37500

(1.0075)^240/{ (1.0075^240)-1}=6.00915/5.00915=1.19963

EMI E=37500 x1.19963=44986. It means you have to repay equated monthly installment of Rs 44986 for 240 months to liquidate your loan of Rs.50 lacs.

Now your first payment of Rs.44986 is apportioned as under

Interest for the first month for the loan amount of Rs.500000 is (5000000 x 0.0075) i.e. Rs. 37500. So Rs.37500 will be towards interest out of EMI Rs.44986 paid by you and the remaining Rs.7486 will be paid towards reduction of principal loan amount i.e. 5000000-7486=4992514. In the second month, interest will be calculated on a loan balance of Rs4992514 that is 4992514 x 0.0075 =37443.85. So Rs.37443.85 will be towards interest out of EMI Rs.44986 paid by you and the remaining Rs.7542.15 will be paid towards reduction of principal loan amount i.e. 4992514- 7542.15= 4984971.85. Hence loan outstanding after payment 2^{nd} installment will be 4984971.85. Likewise, the loan balance and interest on loans continue to reduce every month. In the penultimate month loan outstanding will be Rs.44650. From the last and final EMI of Rs 44986, you will be paying Rs.335 towards interest on a loan amount of Rs.44651 and the remaining Rs.44651 will be adjusted towards the principal loan amount, and loan outstanding after 240^{th} installment will be zero.

If the loans are sanctioned at a flexible rate of interest and you have a fixed EMI, you may have a short-term cash flow mismatch in your loan account. In case the interest rate is increased, your bank may increase the tenure of the loan, and your EMI burden comes down. But longer tenures mean payment of larger interest towards the loan and make it more expensive. However, if the interest rate comes down over the period, you will be repaying the loan before the tenure fixed for repayment of the loan.