To all the music fans out there: Curb your enthusiasm. This article is not about that EMI – one of the world’s most famous record companies, (former) home to the Beatles and Radiohead.
No. This article is about car finance, plain and simple.
We’ll explain what the abbreviation EMI means, why it is vitally important and what you can do to put it to your advantage.
Let’s begin by explaining what, exactly, we’re talking about here.
What is the EMI?
The term EMI stands for Equated Monthly Instalments.
Simply, this is the amount you transfer to your lender at the end of each month to repay your car loan.
The amount is calculated at the beginning of your loan term. Importantly, it doesn’t change over the course of the term. Experts call this a fixed-rate loan. The fixed nature of these rates also explains why we’re talking about an ‘equated’ instalment here.
In car finance, fixed rate loans are by far and large the most widely used type of loan. In theory, you could also buy a vehicle using a variable rate loan, which is adjusted to the current interest rate level. But although these are still fairly popular with mortgages, they never quite caught on in the car industry. (Which is almost certainly for the better.)
How do I calculate my equated monthly instalments?
Now, you know what an EMI is. But how do you tell what your monthly instalments will amount to when comparing loan offers?
Here’s the easy equation to work out the EMI:
EMI = principal amount + interest paid on the loan
Some people, especially with the Corona epidemic cutting into everyone’s budget, only pay the interest on their loan. This is the bare minimum, as it’s still giving the lender what she’s owed. But it also means you’re not actually reducing the loan. At some point, you will need to cover a final balloon payment, which can be quite substantial.
This is where the principal comes in. By adding this amount to the EMI, you actually pay off the loan. The higher the principal, the faster you can settle the score and become the owner of your car.
How do the EMI fit into car finance?
EMI are a vital part of car finance.
For one, they effectively fix the length of the car loan term. As mentioned, there’s a very simple logic at play here:
The higher the equated monthly instalments, the shorter the loan term. Vice versa, the lower the EMI, the longer you will need to pay off your debt.
Now, it would seem as though high EMI were preferable. Still, there are a few principles at work here which explain why some people pay a high EMI and others will go for a fairly low one.
Let’s take a look at them in greater detail.
Your principal depends on your preferences and your financial power.
As we just explained, the equated monthly instalments comprise of two parts: The principal, which is the amount you subtract from the loan each month. And the interest, which is the cost of borrowing the money.
If your EMI are high, then either your principal is high or your interest is high or both.
Let’s talk about the principal first.
A high principal means you’ll own the car faster.
If you can afford it, you will probably want to pay off the loan as fast as possible. For one, the shorter the term, the cheaper the loan becomes. Most lenders prefer shorter terms, because it means they’ll get their money back faster – and they’ll typically reward this with lower interest rates.
Also, the quicker you become the owner of your car, the sooner you can benefit from not having to pay your monthly contributions anymore.
On the other hand, high EMI eat into your savings.
This can turn into a serious problem if you should unexpectedly run into financial trouble. Examples of this are losing your job, being forced to work part time or having to cover high medical bills. In all of these cases, EMI turn into a liability. They also restrict your other expenses each month, from being able to go out for lunch once in a while to buying your kids presents for Christmas.
So you may find it preferable to keep the instalments slightly lower as a safety valve.
Now, what about the second component of your EMI, the interest? There’s a somewhat paradox logic at work here:
To keep interest payments low, you may have to accept a slightly higher principal.
This is because a higher principal adds security to the deal from the perspective of the lender.
Simply put, tour interest depends on your financial past and your current financial status. It goes without saying that you will want to keep the principal low if you can not afford to commit to high recurring payments each month. At the same time, the weaker you are financially, the higher the second part of your EMI, the interest paid on the car loan, will be.
The interest expresses two things:
- The cost of borrowing. Each lender will want to make money on a deal. The higher their expectations, the higher the interest.
- The risk of lending to you: if you should default on your loan, the lender may end up losing money on the deal. The weaker you are financially, the higher the risk of a default. To compensate for this risk, interest is higher for those with bad credit.
Banks and dealers typically take into account several factors when calculating the interest on your loan.
Your financial past is one of them. One of the easiest ways of putting a number to it is your credit score.
But of course, your current financial status also matters. The higher your income, the more stable your job and the more you have available on the bank, the safer you are as a creditor. A higher principal signals confidence and financial security. Your interest will drop accordingly.
Is there a perfect EMI?
This is an important question.
Again and again, you will hear experts say that a short loan term should be your main concern. Yes, they will admit, this will lead to higher EMI. But in return, you’ll pay less in interest and become a proper owner faster.
What they’re forgetting is this: If you end up defaulting on your loan because you can not keep up your ambitious schedule, then all of these benefits do not amount to much.
Obviously, however, if you pay very little in principal each month, the loan becomes more expensive as well – this time, because of high interest payments.
So there is definitely a sweet spot between these two extremes.
How to optimise your equated monthly instalments
Thankfully, there is a three step plan to optimising your EMI. Follow this to arrive the loan rate that’s ideal not for the experts, the dealer or the bank – but for you.
- 1) Make a downpayment: A downpayment is the most effective way of reducing interest on your loan. Even if you want to keep your monthly instalments as low as possible, a downpayment will reduce interest and bring the loan term down. Even with limited financial capacities, you can save up to such a payment. £1,000 can make a huge difference.
- Improve your credit score: Your credit score will determine, to a not insignificant degree, how much you’ll need to pay in interest. The better your score, the better your chances of a good deal.
- Increase the principal: The funny thing is that most borrowers are afraid to commit to a higher principal for fear of high instalments. At the same time, reducing the principal leads to high interest rates – and, thus, also to higher EMI. So, try to pay off the loan as fast as you can. Don’t exaggerate – high EMI are risky, too. But do try to make this your priority. You’ll reap the rewards soon.
Have you read?
How to improve your credit score
Work out your EMI with our online finance calculator
As you can see, there are trade-offs here. Although the math isn’t hard, it takes a fair amount of calculating to get at the best results.
Enter our online car loan calculator. With this simple and incredibly effective tool, you can run through all possible combinations of interest rates, loan term and EMI, depending on your financial status.
In the end, we’re sure you’ll find the combination that’s best for you. After that, it’s off to our digital showroom, where we present a wide selection of exciting and reliable cars. And that should be music to your ears, even if you hate finance and crunching numbers.