If you take loan from a bank or a financier, you have to take care of certain facts in connection with the compound interest that is usually considered and more importantly, the repayment schedule. Interests are generally calculated periodically after one month or each day or sometimes in every three months. The calculated interest on the principal value (the amount of loan taken) is added with the principal itself and then the repayment amount (the installment) is deducted from this sum to arrive at a balance amount.

At the next step, the interest is calculated on the last balance amount and the new reducing balance amount is obtained in the same way. Balance amount = Previous balance amount + Interest on the balance amount – Repayment amount. This process is continued iteratively until the recalculated balance reduces to zero. If the repayment amount is to be given every month and a fixed amount is decided to be returned every month, it is termed as EMI (equated monthly installment). The period over which this repayment process will go on is decided by the amount of EMI, given a certain rate of interest. Conversely, the EMI can be decided if the exact number of installments for repayment is decided. For a fixed interest rate, the EMI and the number of installments can be fixed once for all (not exactly). For the floating interest rate, the EMI has to be decided over a projected period of repayment considering possible small revisions of interest rates.

We get panicked as some odd amount is often thrust upon us by the banks or financiers. Things remain sufficiently unclear (sometimes hidden) as we scratch our head- what to do? First we have to think if the mathematics is alright. There has to be careful scrutiny of any hidden amount or some misleading facts which may complicate the matter. The calculations can be easily done with a hand calculator or writing a small computer program. If you are keener, you can write an elementary algebraic formula to fiddle with.

Usually, if you take loan on the condition of floating interest, a EMI value is given to you when the loan agreement process is complete. The amount must be greater than a minimum value (‘critical’ amount). The critical value of EMI is basically the calculated interest at each month. The payable EMI amount should definitely be greater than this critical value as the balance amount has to be kept reducing to get it over finally.

For a loan of Rs.1 lakh with the floating interest rate of 9.5%, the critical EMI is around Rs.792. Therefore, the payable amount that is to be decided should certainly be more than this amount. If now the EMI is settled to be Rs.1000, the total loan is repaid within a period of 16 and half years. (One thus ends up in repaying Rs.1000 16.5 12 = Rs.198, 000 over the entire period.) If the EMI is decided to be Rs.800 then the loan period extends over a little more than 48 years! (In this case one ends up in repaying around Rs.800 48 12 = Rs.460, 800!) On the other hand, if the EMI is decided to be heavy, like Rs.1500 for example, the loan period ends within 8 years. (The total repayment is now Rs.1500 8 12 = Rs.144, 000 only.) In the course of repayment, if the interest rate is hiked, the critical EMI amount gets shoot up and the payable EMI should thus be increased in accordance so as to bring down the loan period. The general principle is that our payable EMI should be as far away from the critical amount as possible. The more we take time to repay the loan amount, the EMI may be within our comfortable margin, but we compromise in repaying larger and larger amount in aggregate over the entire period. If we think that is a huge loss then that is to be. The mathematics clearly says that. We are only buying time with that huge extra amount of money that we are forced to shell out. (So clearly, time = money, ha!)

All the interest calculations that are done most of the time, however, made on the initial loan amount whereas the rate hike comes into play after a period of repaying a certain amount of loan considering previously lower interest rates. Thus the actual number of installments, for example, will be somewhat less than that are mentioned here. The calculations have to be made on the actual balance amount every time and this fact is important to be checked from the bank statement.

The financiers or the financial advisers will perhaps all these things in mind (and what’s more) and give you some obvious tips like increasing the EMI or the time period or to pay a lump sum at some point to reduce the balance amount in a big way. However, you may play around with the simple calculation of compound interest and decide yourself!