High EMI Vs. Low EMI

Many people these days are facing cash crunches. And it’s easy for us to say that they shouldn’t take personal loans and they should have had emergency funds in place for such times. But the fact is that life has a knack of surprising and not everyone is prepared every time.

So people will have unexpected, unplanned needs and emergencies and they will borrow.

In fact, in the current crisis, the lenders have come out with something called Covid 19 Personal Loans too.

But when it comes to loans, the fundamentals remain the same.

And what are these fundamentals?

I am sure you would know them.

Like the very first being that trying to borrow the minimum amount that serves your purpose. Just because you can avail a bigger loan, don’t go overboard. Remember, that each Rupee you borrow has to be paid back with interest. So the less you borrow, the better it is.

What else?

Try to borrow at the lowest rate of interest possible. It’s a no brainer actually. And these days, you will be able to find some pretty low personal loan rates if you do your online research properly. Many sites will tell you that you can find the best online loans here. But make sure that apart from your online research, you also check with your existing bank. It’s possible you might get personal loans at very attractive rate there itself as you have an existing relationship with them.

But its also true that at times, you will have to accept even higher interest rates if the loan amount you need is available from a lender who is charging higher.

By the way, don’t just look at the interest rate being offered. If you have to borrow make sure to read the fine print or ask the lender whether the loan is being given on a flat-rate basis or a reducing-balance basis. Another is that the interest cost is not the only cost that you pay. There are charges like Processing Fee, Prepayment Fee, Late Payment Fee, etc. Lower all these charges are, the better for the borrower.

Now let’s come to the core topic:

Loan EMI and Loan Tenure

The mathematics of the personal loans (or for that matter any loan) is such that the loan tenure selected along with the loan amount and the interest rate determines your final EMI.

Now comes the actual question:

Should you opt for a shorter tenure & higher EMI? Or go for a longer tenure & lower EMI?

Before we find out the right answer, understand that it also depends on your repayment ability*. Your income is limited. And you have regular expenses to take care of too. So there is a limit to how big an EMI you can actually afford.

Right?

* You will assess your repayment ability from your side. Even the lenders assess borrower’s repayment capacity by computing something called Fixed Obligation to Income Ratio (FOIR), i.e. the % of income being consumed in loan repayments. Generally, if your FOIR is above 40-50%, no new loans will be given to you.

Now let’s see what the maths tells us about picking between the two:

Suppose you avail a personal loan of Rs 10 lakh at an interest rate of 14%. Then your EMI will be as follows depending on the loan tenure of the loan:

  • 5-year Tenure – Rs 23,268 per month
  • 4-year Tenure – Rs 27,236 per month
  • 3-year Tenure – Rs 34,178 per month
  • 2-year Tenure – Rs 48,013 per month

Obviously, many would be attracted to the lower EMI amount offered with longer tenure. But wait. Before you pick that, understand what is the impact of lower EMI (and longer tenure) on the total interest you pay to the lender. The loan principal is Rs 10 lac. In addition, you pay interest at 14% over the loan tenure. How much is the interest? Here is the answer for different tenures:

  • 5-year Tenure – Rs 3.96 lac
  • 4-year Tenure – Rs 3.11 lac
  • 3-year Tenure – Rs 2.30 lac
  • 2-year Tenure – Rs 1.52 lac

Now you see?

Smaller the EMI, the higher will be the interest paid. And ideally, you wouldn’t want that.

Of course, you need to consider EMI affordability too.

But I hope you understand what I am saying. If you can increase your EMI a bit, you can easily save a lot of money on interest. I did a similar analysis for home loans, i.e. how Shorter Home Loan tenure reduces Total Interest outgo.

Ideally, you should keep the loan repayment period as short as possible. More so if you are taking an unsecured loan like a personal loan. The reason is that it will reduce your total interest burden during the loan tenor. Although your EMIs for a short-tenor loan would be higher than a longer-tenure loan, it makes mathematical sense to reduce your total interest outgo.

So first, figure out what is the monthly EMI amount that you can comfortably manage. And then manipulate the loan tenure and/or the loan amount to arrive at an EMI that is affordable for you. Once you have taken a personal loan, you should regularly pay your EMIs. It’s a no brainer actually. And such disciplined repayment behaviour improves your credit score as well. This can help later as having a good Cibil score will work in your favour and increase the chances of loan approval.

Lowering your loan EMI and keeping more money in hand is indeed tempting. But it’s not good financially. No doubt the longer duration personal loans help reduce EMI. But the total interest paid also increases as the loan tenure increases. So whenever possible, choose the shortest tenure for which you can manage EMIs comfortably.

And what about credit card vs personal loan angle?

It depends. A credit card is better for smaller amounts that you can easily repay in a few weeks. But if the amount required is big and you can only repay it over the next few months or years, then taking a personal loan is advisable.

That’s it.

Just remember that all loans should be taken cautiously. It is borrowed money. You have to repay it back eventually. And longer it takes for you to repay, more interest you will pay on every Rupee borrowed. So don’t borrow unnecessarily just because pre-approved loans are being offered.

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